Assessing Quality - Learnings from 7 Powers

Using Hamilton Helmer's framework to evaluate great companies

Dear Readers, being able to identify the quality of a company is perhaps the most important skill to have as an investor. Having a good business strategy is central to a good quality company. For today’s post, I thought it would be good for us to take some time to review one of best known frameworks in business strategy, the 7 Powers as written by Helmer. The core concept has been talked about by many great investors using slightly different verbiage. However, among all the ones I’ve read, I think Hamilton Helmer’s framework lays out the concept in the most comprehensive and clear way.

Investing at its core is about finding companies with a desirable combination of quality and price. That’s also what I select for in my criteria for evaluating stocks. But if you had to pick one, many super investors would actually prioritize quality over price. Some notable examples include:

• Warren Buffett - It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

• Charlie Munger - Great businesses are very hard to find. If you find one, you should be willing to pay up.

• Terry Smith - If a business is high quality, it will compound your returns over time, regardless of whether you paid a slight premium at the start.

• Peter Lynch - Great companies in lousy industries can still do well, as long as the company has some inherent advantage.

One could say finding a great company is the most important part of the investing process.

But what constitutes a great company?

This is where art meets science.

One of the most popular books on business strategy, 7 Powers: The Foundations of Business Strategy by Hamilton Helmer lays out a nice framework for thinking about this question.

In this post, I first summarize my key takeaways and interpretations from this framework. We then evaluate 2 companies within our Swan Select Portfolio based on the 7 Powers outlined to better refine our understanding of these investments.

So what is Power?

Before summarizing the 7 Powers, it’s important to first define what Power is.

Surprisingly, it’s not that different from this!

Helmer defines Power as a set of conditions creating the potential for persistent differential returns.

Much like Superman’s power of flight lets him get to places consistently faster than we can walking.

In simple business terms, Power just means something the company has that lets it consistently make more profits than their competitors. Sounds like a great company right?

Helmer further lays out the framework for each power as measured by 2 specific attributes:

• Benefit - This is a measure of how much more profit you can make because of the Power either through price increases, cost reductions, or less capital expenditure. The magnitude of the benefit determines the value of the Power.

• Barrier - This is a measure of how well you can keep other companies from copying you. This is an important concept in finding good investments as Barriers are harder to establish than Benefits. Warren Buffett for instance, famously uses the term Moat to describe a similar concept. The duration of the Barrier determines the value of the Power.

The 7 Powers

Now let’s review each of the 7 Powers:

Power 1 - Scale Economies: A business in which per unit cost declines as production volume increases.

• Benefit - reduced cost

• Barrier - prohibitive costs of market share gains.

This Power is defined by being so big that you can spread your fixed costs over more units such that your competitors can’t compete with you on price. The example given in the book was based on Netflix which has substantial costs associated with making new shows. However, that cost is spread over all their many subscribers. If another smaller company wanted to compete, they would need to make the same amount of content but the cost would be spread over fewer subscribers. Once this reaches a certain level of disparity, it can no longer be overcome and the Scale Economy advantage can be considered a Power.

Power 2 - Network Economies: A business in which the value realized by a customer increases as the installed base increases.

• Benefit - can charge higher prices due to more value

• Barrier - prohibitive costs of market share gains.

This Power is similar to Scale Economies except the advantage gain comes from the users themselves instead of on the product cost side. All the social networking sites work off this concept as the site becomes more valuable the more people there are on it.

Power 3 - Counter-Positioning: A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.

• Benefit - The new business model is better than the incumbent’s which allows either lower cost or higher prices.

• Barrier - Incumbent can not adopt the new business model without significant damage to their existing business so the damage outweighs the benefits.

This Power is interesting because it’s only a Power against the current leader company. For example, when Netflix started mail-in DVD orders with no late fees, Blockbuster was the incumbent. However, Blockbuster was reluctant to adopt this new model because so much of their revenue came from late fees that it would cause more harm than gain.

Power 4 - Switching costs: Switching costs arise when a consumer values compatibility across multiple purchases from a specific firm over time.

• Benefit - can charge higher prices and sell add-on products which in turn can further increase intensity of this Power.

• Barrier - Competitors need to compensate customers the switching cost. This makes it more costly to gain market share to the point of making it undesirable.

This Power is based around around the idea of stickiness. Once we’re used to doing something one way, it takes active effort to try something different. After all, if you have an iPhone, when was the last time you thought about getting an Android? Importantly, this Power also has a limitation in that it only applies to the existing customer base the company has but doesn’t help with bringing in new customers.

Power 5 - Branding: Branding is an asset that communicates information and evokes positive feelings in the customer. This directly elevates the value of the product to the customer.

• Benefit - ability to charge higher prices for same product because it either evokes positive feelings or reduces uncertainty about quality.

• Barrier - Branding can only be created over a long time so others in present day can’t copy it.

Branding is probably the most psychological of all the Powers since the value provided is often difficult to quantify. Hermes for example can make a leather bag with the same functionality as a bag from Target but charge many many times the price simply due to the brand.

Power 6 - Cornered Resource: Preferential access at attractive terms to a coveted asset that can independently enhance value.

• Benefit - Can vary depending on the resource from better product, preferential access, or lower cost.

• Barrier - “fiat”, by some general or personal rule that the resource would not be available to competitors. For example, patents or an employee who stays at a company out of loyalty, not financial reasons.

This Power captures the cases where the company is just better because of something other companies can’t have. For example, Warren Buffett himself is a cornered resource for Berkshire since his name alone get preferential access. Obviously, he would not go to a different company.

Power 7 - Process Power: There are unique and hard to replicate processes that becomes a part of a company and can only be matched over a long period of time.

• Benefit - Improved product attributes that is maintained and sustainable. Does not change as a result of workforce changes.

• Barrier - The complexity and opacity of the process makes it difficult to replicate even with instruction due to how long it took to develop

This Power is described in the book as operational excellence + hysteresis. In other words, just operational effectiveness alone is insufficient. Rather, it needs to be operational effectiveness that was developed over a lengthy period of time to create the Barrier against copying by others.

The What and When

In the final 2 chapters, Helmer spends some time discussing the What and When of developing Powers. These chapters are a bit more vague but it highlights that Powers develop as a result of invention. For example, the invention of generative AI in these last few years may well result in Powers developing in some companies. Our goal as investors is to find them.

Helmer also provides a bit more context on when Power can reasonably develop. Knowing this can also help identify what Powers can reasonably be expected. Breaking down the timeframe from invention as Origination, Takeoff, and Stability. The latest that Powers can develop are as follows:

• Cornered Resource and Counter-Positioning can develop starting from Origination

• Scale Economies, Network Economies, and Switching Costs can develop starting from Takeoff

• Process Power and Branding can only develop during the Stability phase

Ok, so let’s apply this theory to evaluate some of the companies in our Swan Select Portfolio to determine what Powers they currently possess. Through this framework, it helps make more evident when we assess a company as “good” and when we assess a company as “great”.

Application - Evaluating Companies

Take a well run company like Valero from our Swan Select Portfolio for example. Reviewing Valero’s business strategy using the 7 Powers framework, we see that Valero primarily has Process Power. The company is impressively efficient compared to industry peers. We also know that this is not something that can be easily copied by competitors even though the refining process itself is not a secret. Valero has been able to do this consistently year after year implying it is likely something embedded into the company culture and know how.

Now some may argue that Valero also has the Economy of Scale Power. However, this is not really true when assessed against Valero’s existing competitors. Some like ExxonMobil and Marathon Petroleum are also very large.

Ultimately, Valero’s Process Power gives it a sustainable advantage within the industry which is why I grade it as a good company worth investing in.

Let’s now take a look at an example of a great company within the Swan Select Portfolio, Amazon. What gives Amazon that sustainable edge? A closer look using the 7 Powers framework reveals Amazon has 5 out of the 7 Powers:

• Scale Economies - Amazon’s size allows it to lower fixed and logistics costs preventing other competitors from matching their price with the same level of service. This has been shown through their interactions with UPS previously and now through their capital expenditure investments in robots and AI.

• Network Economies - Amazon naturally benefits from network economy as it allows sellers and buyers to find each other. This creates a natural network effect since every new buyer that joins gets access to all the existing sellers and every seller that joins gets access to all the existing buyers on Amazon.

• Counter-Positioning - Amazon as an e-commerce company is also counter-positioned against the brick and mortar stores. Companies like Walmart have a hard time competing against Amazon simply because it would disrupt and hurt their existing retail business. Trying to mimic Amazon’s e-commerce business would also lower their existing margins which is undesirable. This was a stronger Power in the earlier days but is still worth calling out.

• Switching Cost - Amazon’s AWS system is quite expansive for companies and once this is invested in their infrastructure, becomes prohibitively expensive to change.

• Process Power - Amazon’s culture enables a process by which the company is able to implement new ideas successfully and rapidly. It then uses these to create unique advantages. This is very difficult to replicate. I allude to this a bit in my original thesis for Amazon as “hidden potential”. This has led to some major competitive advantages over time such as the early creation of AWS, superior logistics through 1-day Prime delivery, and Amazon Prime Video.

So what Powers do your investment choices have? Understanding this will help you select better quality companies to fulfill the Quality half of your assessment. If you also want to learn more about the Valuation half of assessing investments, check out the Discounted Cash Flow Tutorial next.

If you enjoyed this content, consider heading over to our Table of Contents to see what else you may have missed.

Disclaimer: Any information contained here is not intended as, and shall not be understood or construed as, financial advice. I am not a financial advisor and this is only a documentation of my personal investment journey and decisions. It should be noted the author may own positions in the stocks discussed in this blog which could create a conflict of interest. You should always do your own research before making any final decision on investments.