Porter´s (1980) Generic Strategies, Performance and Risk

MA-Thesis / Master von Jan Eldring

Introduction:

In the summer of 2006 the board of Volkswagen announced the withdrawal from the luxury class market in North America, due to unsatisfactory results with the Phaeton. The Phaeton is Volkswagen’s most prestigious project that should attack luxury carmakers as Mercedes or BMW. More importantly the Phaeton should upgrade Volkswagen as a brand, moving away from the image as a ‘people’s carmaker’ to a high-end carmaker for business people as well. Unfortunately the customers did not perceive Volkswagen as a producer of luxury class cars, even though tests have shown that the Phaeton could actually compete against Mercedes or BMW on a technical level. After drawing a balance the board decided to withdraw the Phaeton from the North American market. On the other hand there are also success stories within the car manufacturing industry. Porsche for example, is able to outperform its competitors by bringing products to the market that set high value on quality and status. Thereby Porsche became the most profitable carmaker in the world. The other extreme is Toyota. They outperform its competitors by bringing products to the market that are priced well below market average.

This case from the car manufacturing industry illustrates a good example, in order to introduce the reader to the complex topic of corporate strategy and strategic choice. Firms such as Porsche and Toyota lie at the edges of the strategic spectrum, whereas Volkswagen underperforms since several years, because their products neither appeal to quality-conscious nor price-sensitive customers. However Volkswagen is able to generate profits that defend its position as the biggest car manufacturer in Europe, although the firm cannot be assigned to one of the extreme points in the strategic spectrum, as for example Porsche or Toyota. Apparently these three firms can be separated on behalf of their strategic choice. The question then ultimately arises, why firms choose a certain strategy? Why is Volkswagen not trying to compete on price with Toyota or trying to compete on outstanding products with Porsche? Certainly that is easier said than done, since definitions of successful strategies have not led to consensus yet in the academic world. Several researchers formed the foundation for successful corporate strategies. Among others Miles and Snow proposed defender, prospector, analyzer and reactor strategies that determine the success of a firm. Their typology has been implemented and formed the foundation for prospect and growth. Another typology that is widely discussed is from Tracy and Wiersema, who identified three value disciplines that can function as a successful corporate strategy (operational excellence, product leadership, customer intimacy). March proposed a dichotomy between exploration and exploitation that a firm is facing and that corporate strategy is a result of allocating resources. Without going too much into detail, it is striking that these typologies have more similarities than differences, when having a closer look. Thus, cost efficiency is repeatedly identified as one corporate strategy, meaning that firms compete at a lower level of product performance, but at significantly lower prices. Another similarity among most typologies is focusing on innovation, differences in product features or performance levels. The rationale behind these similarities is because resources are not limitless and firms have to make a trade-off to find their position in the production possibility frontier.

The study that is most acknowledged and best summarizes the possibilities a firm has with respect to strategic choice, is from Michael Porter. He proposes three generic strategies that can lead to a competitive advantage in an industry: cost leadership, differentiation and focus strategies. All other strategies are hybrid strategies that are much more vulnerable to attacks on either flank of the production frontier. A pure cost player is able to underprice the hybrid competitor and differentiators lure away quality-conscious consumers from the hybrid competitor. Several academic studies confirm that this typology can be seen as a foundation for separating successful and unsuccessful firms on behalf of their strategic choice. All in all Porter advises firms to choose one of the three strategies for the long term, in order to stay competitive.

Coming back to the example above, Porter’s theory perfectly describes the success factors within the car manufacturing industry. Those firms that operate at the edges of the strategic spectrum (e.g. Porsche, Toyota) outperform those firms that have hybrid strategies (e.g. Volkswagen). Nevertheless Porter’s theory is less useful when asking about Volkswagen’s motivation to operate with a hybrid strategy. It is unlikely that the management of Volkswagen is not aware of the fact that their competitors are more successful with a pure strategy. What then drives firms to implement hybrid strategies, knowing that they are less successful?

Just recently Michael Raynor challenged Porter’s widely accepted typology, by including another dimension in the discussion that previously did not find consideration: risk. He claims that firms that execute pure strategies are much more exposed to corporate risk than firms that execute hybrid strategies. Two arguments support his view. First Porter’s and other studies include what is called a ‘survivor bias”, meaning that firms that went bankrupt during the investigation (with a pure strategy) do not play a role in the analysis. Second firms that have hybrid strategies are much more flexible when market preferences shift and are therefore less exposed to strategic uncertainty. All in all Raynor’s work is a valuable extension to the strategic management literature that leads to an assessment of strategic choice on at least two dimensions: profitability and risk. A thorough discussion about this topic forms the foundation of the study:

Porter’s generic strategies do not solely explain strategic choice of firms, since the reduction of corporate risk is a viable motivation for firms to choose a hybrid strategy.

The contribution of the study is then twofold. First Porter’s typology is tested with German data. Secondly Raynor’s argument is tested, whether the very same firms that are more successful have a higher risk of running into corporate bankruptcy.

In order to have the necessary information, the first section of the paper reviews the literature. Here the generic strategies are explained and the most important studies on the topic are summarized in a table. Then the ‘Strategy Paradox’ is presented that describes Raynor’s argumentation for an increase in risk with pure strategies. Two conflicting theories are mentioned that deal with the question whether risk and return is positively or negatively related. In between this first part, two hypotheses are given that are tested with data from the Centre of European Economic Research in Mannheim (ZEW). Section 3 presents the dataset, the variables and the methodology. The results are analyzed in section 4 and the differences in performance and risk are compared among the strategic groups. In section 5 the most important results are discussed and potential explanations are given that lead to suggestions for further research. Additionally implications for managers are proposed and the limitations of the study are mentioned. The paper ends with a conclusion and a personal view on the discussion.

Table of contents:

Text Sample:

Chapter 3.3, Measurement of Risk and Variable definition:

Several different measures of risk have been discussed in the strategic management literature. In order to evaluate which measure of risk is appropriate for the study at hand, it is helpful to review recent findings on the significance of risk measures. This is done in the next section as well as a presentation for the variables chosen for the study at hand.

Miller and Bromiley identified three groups that represent the variables used in the literature to measure risk: stock returns, financial ratios, and income stream uncertainty. In the first group, stock market returns, systematic risk and unsystematic risk are measures of risk. Systematic risk is the sensitivity of the return on a firm’s stock to general market movements. Unsystematic risk is a unique firm or industry risk, not shared by the market in general. Investors can eliminate unsystematic risk through portfolio diversification. Various studies have used systematic and unsystematic risk as a risk measure. Aaker and Jacobsen found that systematic and unsystematic risk have a significant positive influence on performance from a shareholders’ perspective. The logic behind their argumentation is that firms with high unsystematic risk tend to have problems attracting better managers that can improve performance.

- The second group of risk measures is based on financial ratios, such as the debt-to-equity ratio, capital intensity, and R&D intensity.

- The debt-to-equity ratio is a standard measure in corporate finance to measure a firm’s risk of bankruptcy. It measures the relationship of a firm’s total debt to the sum of common equity. A firm’s risk of bankruptcy increases with an increase in debt. Capital intensity is the ratio of capital to sales. Corporate risk increases if a firm uses large amounts of capital that can become obsolete if technological change makes a capital investment worth little or nothing. R&D intensity reflects the extent to which a company chooses to develop new products. Uncertainty about the successful development of new products is twofold.

First a firm does not know specifically the relationship between R&D investments and the actual introduction of new products. Second the firm does not know specifically if rivals introduce products that affect the value of the R&D investment. R&D intensity is measured by the ratio of R&D expenditures to sales.

- Stock returns and financial ratios cannot be taken into account in this investigation due to a lack of financial data about capital structures or stock prices. Therefore the study focuses on the third group of risk measures: Income stream uncertainty. Income stream uncertainty includes historical returns variability and measures derived from analyst’s forecasts. In strategy research, historical fluctuations of income streams are among the most common risk measures, because reductions or fluctuations in revenues often result in unpleasant managerial actions, such as lay-offs or reductions in capital investments. Stable revenues though, result in the adequate implementation of corporate strategies and increase the stability of employment, which reduces the firm’s risk. Risk measures derived from analysts’ forecasts interpret deviations in earnings per share as an indicator about the uncertainty for future income streams.

Miller and Bromiley point out that the best proxy for measuring risk is revenue volatility, because stable revenues make it easier for management to deal with different stakeholder groups. The greater the amplitude of fluctuations, the higher is the probability that a firm will come in financial distress in the future. This can be examined by measuring the fluctuations of revenues from past years.

The survey (Appendix I, question 1.6) provides data about revenues from three years. These revenues form the basis of the risk variable, because the fluctuations of the revenues are measured on behalf of a variance formula.

Main Variable:

According to Porter’s taxonomy strategic memberships of firms (Appendix I, question 10.1), form the foundation for the independent variables of this study. Firms are categorized among cost leadership (‘cost leadership’), differentiation (‘technological leadership’; ‘industry leader in bringing new products to market’; ‘industry leader for the implementation of new processes and practices’) and focus (‘individualized solutions to customers’; ‘specialization on market segments’).

A fourth group is implemented, which represents those firms that do not have a clear strategic orientation towards one of Porter’s strategies (‘stuck in the middle’). Since firms rate for themselves which strategy they pursue, it is assumed that strategic membership is precisely examined.

Firms can choose among four scales in how far they pursue a strategy. Porter’s strategies are detected if a respondent ranks its strategy on one of the three possible categories at the highest scale. If there is no clear categorization possible than a firm comes in the fourth group, stuck in the middle. This procedure helps to clearly separate those firms that concentrate their strategic orientation towards one of Porter’s strategies and those firms that have multiple strategic orientations.

- Figure 4 shows the distribution of strategic choices among the sample under investigation. From the 3.606 firms 152 can clearly be characterized as firms with a differentiation strategy, 392 firms have a cost leadership strategy and 334 firms have a focus strategy. The biggest fraction is the fourth group, stuck in the middle with 1836 firms. Firms that are neither considered as firms with a Porter strategy, nor stuck in the middle (n=892), have strategies that cannot clearly be assigned to one of the four groups. Examples include firms that have their main competencies in forming alliances, or reacting to innovations from competitors. These firms are not considered for further analysis.