Advantage Flywheels

Competitive advantage can be represented visually as 1 or more feedback loops. These create the advantage “flywheel” that maintain and grow a moat over time. Think of a big, heavy wheel that takes some effort to get started but then coasts off its own momentum.

Before continuing, check out Eric Jorgenson’s primer on the flywheel mental model here.

Flywheel archetypes

Here are 6 simple examples of common advantages represented as flywheels (or “causal loops” in systems terminology). These loops are generalized — they’ll be expressed uniquely in every company that has them.

A few examples of how each advantage flywheel can vary:

  • In the Economies of Scale flywheel above, the primary driver of more volume is low prices. This fits for most consumer businesses, but lower prices aren’t always the outcome of lower unit costs. If prices are maintained or increase, scale will yield higher margins → more resources to spend on growth → more sales volume.
  • The Brand Habit flywheel exhibits the typical loop for habit-reinforcing association of a brand with a specific quality or job-to-be-done. Think “thirst quenching happiness” for Coca-Cola and “low prices” for Wal-Mart. Another example of brand advantage is more of a social proof effect: Product has success → the cool kids want it → improved perception of product → …

As Eric discussed in his flywheel post, each wheel needs a push to get started. Written in green on a few of the archetypes above are initial advantages to get the wheels moving. Whether it’s a better user experience, a technical breakthrough, or a bootstrapped network based off of an existing network (college campuses for FB) or a useful utility (Instagram).

Real world examples

The above archetypes can be combined to create more comprehensive flywheels modeling the driving “engines” of each company’s moat:


The most successful moats have multiple flywheels that feed off of each other’s momentum. Google’s technical advantages enable stronger brand allegiance and vice versa. Coca-Cola’s marketing-driven brand feeds off of it’s distributor/bottler based network effects. Facebook’s brands have at least 3 reinforcing network effects: direct (social network), 2-sided aggregator (advertising and developers), and brand-driven social proof.

Friction and limiting factors

In systems thinking, reinforcing feedback loops are almost always slowed by a balancing loop attached to it. Growth doesn’t continue unchecked, and flywheels always run into friction.

Some of these limiting factors are overcome, others are so strong they stop or reverse the entire growth engine.

What are some typical examples?

  • Switching costs & network effects — product quality slips as the incentives to improve aren’t strong when customers can’t leave → value of a competitive offering overcomes switching cost.
  • Learning curve of proprietary tech — hitting top of the S-curve, output efficiency declines, and competitors catch up.
  • Direct network effects — any source of decreasing value to users, which could cause users to exit and turn the virtuous cycle into a vicious one.

Moats Move

Using the analogy of a feedback loop helps to think of an advantage as a moving, changing system. A system that needs catalysts to get started, and will gain momentum at first but still be slowed by friction over time.

When thinking about how a business will grow over time, ask:

  • What advantage archetypes does it fit?
  • Where are the sources of positive feedback?
  • How do you get the flywheels moving? What strategies can help get inertia? (For example, “doing things that don’t scale.”)
  • What are the current or future limiting factors?

Featured photo from Ruth Hartnup on Flickr.
Thanks to Eric Jorgenson for feedback on the final version.

Why big moats can be bad

Large competitive moats play an important roll in determining the current and future success of a business. Moats are barriers to entry that protect the economic castle—from both new entrants, or expansion by current competitors. So the bigger the moat, the better the business, right? For the current and very near future, yes. But huge competitive advantages can become disadvantages when they lead companies to become complacent about their customers and potential alternatives to their product.

On the one hand, you have Wal-Mart and Coca-Cola—companies where consumer preference plays a large role. Wal-Mart has economies of scale that result in lower costs—probably the biggest competitive advantage in all of retail. But as the old saying goes, “retail is detail” and they still have to work hard to get the customer experience right (at least for their price point). If they don’t, competitors like Target and the dollar stores are more than willing to pick up new business.

Coca-Cola also has seemingly large advantages: a powerful brand name due to strong consumer habit and share of mind, plus large economies of scale in global marketing and distribution. Coca-Cola-owned brands account for 3% of every beverage consumed in the world today. But consumer preference still drives this market share, and a single slip-up (like this) can drive customers to the also-dominate #2 in the market, Pepsi.

On the other hand, you have companies with extremely wide moats like Microsoft and Ebay. They essentially have a lock on most of their customers because of high switching costs or strong network effects. Ten years ago, if you used their products and wanted to switch, it would be very difficult. Among other reasons, I think that led them to skimp on product quality and customer experience. There were product updates and improvements, but little innovation compared to alternatives. Why upset the apple cart when people are essentially forced to use your product?

The details matter!

Having a powerful lock on customers can lull companies into complacency. By the time they realize customers  have a good alternative or their business model is being disrupted, it may be too late. For companies who have big competitors or have to constantly cater to customers, it’s easier not to fall into that trap. So if you have the luxury of running or investing in a business with a strong lock on its customer base, remember to sweat the details. Customers will always eventually have an alternative.

Entrepreneurial Arbitrage


Arbitrage is “the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.” Once the arbitrage spread closes, the profit is made and the opportunity no longer exists. According to Austrian Economics, entrepreneurs’ profits “derive from the services he performs in detecting and eliminating arbitrage opportunities, thereby allowing supply and demand for a given good to meet.” By recognizing and acting on opportunities, the entrepreneur moves markets toward equilibrium. So entrepreneurial arbitrage is a low-risk way of exploiting gaps between what the market demands and what it’s being supplied until the spread closes.

There is very little “invention” involved—startups imitate or slightly modify someone else’s idea and only introduce breakthrough products or new business models many years later. This is what Peter Drucker calls creative imitation. The technology and market demand already exist, but the creative entrepreneur understands what the innovation represents better than the original innovators. This also includes packaging current technologies into new business models. Paul Graham calls this an idea that’s “a square in the periodic table”—if it didn’t exist now, it would be created shortly.

Continue reading “Entrepreneurial Arbitrage”

Generalists vs. Specialists (and the Specialist’s Dilemma)

In December of last year, I gave a presentation to a group of investors on the mental models of robustness and generalist/specialist species. Below are some of my findings, along with how these models can be applied to business and investing.

Animal species reside on a scale with “generalist” on one end and “specialist” on the other. Specialists can live only in a narrow range of conditions: diet, climate, camouflage, etc. Generalists are able to survive a wide variety of conditions and changes in the environment: food, climate, predators, etc.

Specialists thrive when conditions are just right. They fulfill a niche and are very effective at competing with other organisms. They have good mechanisms for coping with “known” risks. But when the specific conditions change, they are much more likely to go extinct. Generalists respond much better to changes/uncertainty. These species usually survive for very long periods because they deal with unanticipated risks better. They have very coarse behavior: eat any food available, survive in many climates, use a simple mechanism to defend a wide range of predators, etc. But unlike specialists they don’t maximize their current environment, because they don’t fill a niche where they could be more successful. It’s tough being a generalist—there’s more competition.

An environment with more competition breeds more specialists. Rainforests have huge diversity and competition, and therefore many specialist species.

Specialist examples: Orchid mantis (colorful mantis with appendages like leaves, thrives only on orchids and in tropics), sword-billed hummingbird (beak longer than body, co-evolved with flowers having very long corollas and difficult getting food elsewhere), koala (lives almost entirely on eucalyptus filling a niche that is toxic to most animals).

Generalist examples: Cockroach (survives in most climates, only needs water/moisture and a food source, only defense is responding to puffs of air), raccoon (wide diet, omnivore, lives in any area with trees, brush, or structures), rat (found everywhere in the world but the Artic, not picky eaters), horseshoe crab (wide diet on floor of sea bed, tolerates wide range of water temperature, can survive in low oxygen waters and out of water for extended periods; species over 360MYO).

Specialists & Generalists in Investing

This model can be applied to many different areas.

Investors themselves can be put on the specialist/generalist scale. The most specialized investors focus only on narrow segments of the market or certain types of securities. They can be very successful during certain time periods but in the long run are usually disrupted by a changing investment landscape or black-swan-like event. The most generalized investors use very coarse, unchanging rules and are truly “go anywhere”, willing to buy or sell any type of security around the world. They may underperform or lag behind their specialized brethren in the short term but will likely do well in the long run when averaged out over many different environments. Most investors (including Warren Buffett) lie somewhere in between these two extremes. Specialists include investors in certain industries like Sam Zell (real estate) and Ron Burkle (retail), or in certain situations like Jim Chanos (shorting) and David Tepper (distressed). True generalists are more rare, but include great investors like Ben Graham and Seth Klarman.

Specialists & Generalists in Business

A more interesting application is to the competitive business world. Like in the animal kingdom, generalists are rare and are usually much bigger than the specialists. They include big multinationals like Johnson & Johnson, Wal-Mart, Coca-Cola, and Proctor & Gamble. Also included are conglomerates that may hold many diversified specialists like General Electric or Berkshire Hathaway. Specialists are businesses that focus on a local niche whether in geography or product space. Because many specialists can dominate their niche, they’re usually protected by moats and thus have high returns.

This is what I call the Specialist’s Dilemma. The stronger your competitive position in a market niche, the more vulnerable you are to eventually being disrupted by changes in the business environment.

Let me explain further. Out of the universe of companies that have strong competitive moats, many of them have advantages originating from the niches they occupy. (Which can lead to barriers like economies of scale, brand attachment driven by habit, and being ahead on the learning curve.) These advantages are durable only as long as the niche itself remains viable. In other words, the more specialized a company’s dominance is, the stronger its advantages are — but the higher the odds of the niche itself eventually disappearing. Not disappearing due to competitors within the industry, but due to the niche being completely destroyed and replaced by something else. The timing of when this happens partially depends on the “clockspeed” of innovation within the industry (more on that in my last post).

Just something to think about if you’re a long term investor or business manager.

Pyramids vs. Skyscrapers

Insight: When looking at a company, what type of building is it?

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Finding an Edge

The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.

—William Poundstone, “Fortune’s Formula”

Everyone needs an “edge” in both investing and business. If it were just a matter of finding and purchasing a security below its intrinsic value, anyone could go out and buy “The Intelligent Investor” and become great. In other words, value investing, in and of itself, is not a competitive advantage.

An “edge” is any method that gives an investor a leg up over the market by obtaining higher returns with lower risk. (Risk in this case being the risk of permanent capital loss–or the size of potential loss times the probability of loss.)

From what I’ve seen, there are six basic advantages, each of which can give investors an edge over the market:

  1. Psychological – discipline, patience, and the avoidance of common biases and misjudgments. An extremely difficult advantage to have, but is probably the most common among good investors. (Easier said than done.) Continue reading “Finding an Edge”

Buffett on Franchises

Warren Buffett talks a lot about competitive moats and franchises. However, I think he most succinctly describes his entire philosophy in this short passage:

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management. [From the 1991 Berkshire annual report]

The first sentence basically lays out—in only a few words—the definition of a competitive advantage. So a company can be either a franchise or a business. But the separation between the two doesn’t have to be that clear cut.

Some franchises can be much more lucrative and powerful than others. Both Coca-Cola and Pepsi have moats, but Coke has the upper hand when it comes to customer mindshare. Because of this, Coke has always maintained higher worldwide and domestic market share than Pepsi.

Some companies can have both qualities: they are in extremely competitive industries (where lowest-cost wins), but also share some of the benefits of a franchise. The sit-down restaurant business is extremely difficult to operate in—but chains like In-N-Out and Steak ‘n Shake have created a brand that holds a special place in the minds of customers.

One more thing: I think when Buffett talks about mis-management, he really means short-term mis-management. A long period of poor management can have significant impact on any franchise—even one like Coca-Cola. And even with a strong economic franchise, every investment needs to be monitored just in case the moat starts to shrink (like newspapers over the last few decades).