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The rule of three: Surviving and competing in competitive markets

Book cover

by Jagdish Sheth and Rajendra Sisodia, The Free Press, 2002.

Abstract

Research shows that the top three firms control 70-90% of any market. Specialist companies can have a low share and yet prosper by their niche. In between these two categories life can be difficult and actions are suggested to avoid falling into the trap. How the top three can rise to global pre-eminence is also highlighted.

(Reviewed by Kevin Barham in September 2002)

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Name any industry and you will find that the three strongest, most efficient companies control 70-90% of the market. So say Jagdish Sheth and Rajendra Sisodia, US business school professors of market strategy. (Look, for example, at hamburgers, cereals, trainers and banks in the US where the Big 3 are respectively McDonald's, Burger King, and Wendy's; General Mills, Kellogg, and Post; Nike, Adidas, and Reebok; Bank of America, Chase Manhattan, and Banc One.) The professors say that natural competitive forces shape the vast majority of companies under a 'Rule of Three' which has powerful strategic implications for businesses large and small alike.

Evolution of markets

Drawing on extensive research and plentiful examples and case studies, the authors show how markets evolve into two complementary sectors - generalists which cater to a large, mainstream group of customers; and specialists, which satisfy the needs of customers at both the high and low ends of the market. Any company caught in the middle - 'the ditch' ('the bankruptcy courts' waiting room') - is likely to be swallowed up or destroyed.

Although they wield enormous power, giant firms cannot rely on their size, their alliances, or their command of the market to protect them from aggressive competitors and changes in their industries. According to the Rule of Three, the evolution of competitive market structures favours the strongest, most efficient companies. Four forces combine to promote such efficiency: industry consolidation, government intervention, the establishment of de facto standards (either for products or processes), and a shared infrastructure.

Natural competitive forces, if allowed to operate without excessive government intervention, will create a consistent structure across nearly all mature markets. In one group, three major players compete against each other in multiple ways: they offer a wide range of related products and services, and serve most major market segments. (Other examples include General Motors, Ford, and DaimlerChrysler in automobiles; ExxonMobil, Texaco, and Chevron in oil; Philips, SCS-Thomson, and Siemens in European semiconductors; Sainsbury, Tesco, and The Argyll Group in UK grocery retailing.) These full-line generalists form the core or inner circle of the markets in which they participate.

As a market matures, the Big 3 become better defined and more solidly positioned. Because it is extremely difficult to compete head on against a full-line generalist, smaller players begin to carve out those areas in which they can effectively specialise. Either they become product specialists or they define themselves as market specialists targeting a specific demographic group or geographical region. (Sometimes a company becomes a 'super-nicher', specialising in both a product category and a market segment.)

As markets grow and mature, a third group of participants emerges. These are often too large and diverse to be specialists, but not large enough to compete successfully against the Big 3 as they cannot match the latters' economies of scale and scope. Nor can they meet specific customer requirements as effectively as the specialists. Therefore, they have neither the scale nor the loyalty advantage. They may compete on price and try to reduce costs by cutting product quality and service, but their return on assets (ROA) remains very low, if not negative.

The Big 3 usually control 70-90% of the market, whereas each product or market specialist, by appealing to a small group with specialised needs, controls between 1 and 5% of the market. Companies caught in the ditch typically capture only 5-10% of the market, and cannot compete effectively against either the Big 3 or the specialists.

Financial performance and market share

Financial performance and market share, say the authors, do not usually have a linear relationship - performance does not necessarily improve with market share gains, nor deteriorate with decreases. The Big 3 usually do well; they may have low margins but achieve excellent ROA. The ditch is a major trap for the mid-sized companies - those that are smaller than the Big 3 but bigger than the niche players - whose financial performance is usually the worst of all. Beyond the ditch and further down the scale of market share, financial performance starts to improve as niche players reap the profits of high margins.

The slope of the relationship between market share and ROA is steeply negative for specialists, but shallow and positive for generalists. This indicates that the financial performance of specialists deteriorates rapidly with undisciplined growth in market share, whereas generalists achieve a slow and steady improvement in performance as they gain market share. For generalists, however, performance improvements slow considerably as they expand beyond 40% market share and may even deteriorate.

The financial performance of the Big 3 improves with market share - but only up to a point. Beyond approximately a 40% share, they begin to experience diseconomies of scale and attract the attention of regulators. If the market leader holds a share between 50% and 70%, a third full-line generalist has little room and will either fall into the ditch or be forced to become a specialist. If, on the other hand, the market leader has 70% or more of the market, there is little room for either a second or a third full-line generalist. Such dominance rarely lasts, however, and newcomers will gradually gain a foothold to challenge even the most powerful company.

Balancing efficiency and competitive intensity

Without outside intervention and government controls, competitive markets evolve in ways that ultimately reward the most efficient companies. Markets can evolve so that either they are nearly free of competition, as in the case of a monopoly, or they become so intensely competitive that no one makes any money. Two primary forces exert pressure on all players: (1) the demand for efficiency and (2) the need for relief from excessive competitiveness. These forces exert both a push and a pull effect on everyone. Some markets become so intensely competitive that nearly all participants are strangled. A natural response is to give in to this push by seeking release from the competition, even if lower profits result. In other cases, when competitors raise the efficiency bar, one can feel pulled to compete more fiercely, to move that much faster just to keep pace or to try to break out of the pack. Consequently, profits go to making the business more efficient, sleeker, faster, and more attractive to customers or would-be suitors.

The effects of this relentless drive for efficiency filter down to each of the company's stakeholders. Squeezed for greater productivity but often inadequately rewarded for their contributions, employees become increasingly disgruntled. Customers also feel the negative impact of hyperintense competition. While prices may fall, service often deteriorates. As the company spends more of its profits on new initiatives or the latest technology, shareholders grow increasingly dissatisfied with quarterly announcements of lowered expectations and falling market capitalisation.

When the drive for efficiency results in wasteful hypercompetition, most markets respond with a logical solution. The initial players experience a shakeout. Three dominant players eventually emerge, accompanied by any number of specialists and niche players. This structure offers the best possible balance between efficiency and competitive intensity since the specialists enjoy their high margins and loyal customers while the Big 3 rely on volume to drive up their ROA.

Why three?

The authors claim that a market structure based on three major players is more stable and more competitive than one with two players. When there are just two players, the outcome is either mutual destruction or collusion that is ultimately damaging to customers. Either scenario produces a de facto monopoly. On the other hand, in most markets a coalition of two out of the three is strong enough to block any predatory intentions that the third might have. With three main players, there is less predatory competition as well as a lower likelihood of collusion or mutual destruction. The third player can refuse to collude, or co-operate with the victim to keep the other one at bay, or can pit one powerful player against the other.

Because it offers reasonable customer choice, moderate competitive intensity, and high market efficiency the Rule of Three determines the point of equilibrium in many industries. It is often assumed that customers suffer the most when competition dwindles, but a high degree of market concentration is not necessarily incompatible with consumer welfare. In fact, fragmented markets usually cost consumers more, since no firm can achieve economies of scale and all firms spend heavily on fighting one another rather than serving their customers. The Rule of Three still leaves up to 30% of the market for the specialists, and entry barriers are only entrepreneurial, not legal or regulatory ones. Because only three players are needed to create a balance of power, the fourth player becomes expendable in the market's push toward efficiency. (The Rule of Three is also linked with the theory that customers in both consumer and industrial/commercial markets tend to consider at most three choices before making a purchase.)

Understand your industry's evolution

The authors contend that understanding the Rule of Three will benefit all CEOs and managers concerned with their company's market performance and competitive strategies. Managers need to learn and appreciate their business context. They must understand how their industry is structured, what stage of evolution it has entered, and how that evolution is likely to continue. They can then better cultivate their innate strengths, formulate reasonable strategies to leverage their position within the industry, and maximise their chances of success.

Mature markets can suffer radical disruption when technology or regulation changes or when the entry of a new player alters the rules of competition. Unfortunately, companies often see and hear only what they want to see and hear. Rather than investing real and psychological capital in the status quo, they would do better to adopt a 'crisis imminent' mindset that prepares them for an industry shakeout at any point. The authors describe a number of leading indicators that forward-looking firms can use to anticipate an impending shakeout (eg changes in trade barriers, growing overseas competition, technology breakthroughs, etc.) They also propose strategies for firms in the three competitive sectors.

Strategies for generalists

Both generalists and specialists can generate attractive returns, provided they follow strategies appropriate to their position in their industry and stay out of the ditch. Recommended strategies for number 1 generalist companies include:

  • Be a 'fast follower' in innovations.
  • Push for the adoption of industry-wide standards.
  • Develop world-class marketing and advertising through single or dual global brand positioning.
  • Use multiple distribution channels.
  • Emphasise both low costs and product differentiation, and focus on volume over margin.
  • Grow the market.

Market leaders should avoid dogmatic thinking and sacred cows. They must be prepared to change technologies, kill old products, and adopt new marketing approaches. They should become strategic opportunists rather than resolute implementers of rigidly defined strategies.

Number 2 companies should:

  • Engage in productive marketing.
  • Focus on value.
  • Close the efficiency gap with the number 1 company.
  • Co-exist with the leader through segmentation.

While the number 1 and 2 companies can appear relatively secure, it is not inevitable that number 3 should land up in the ditch. The best defence is to increase market share and build up the ROA. The advice for number 3 is to:

  • Innovate and differentiate.
  • Concentrate resources for best opportunities.
  • Promote vertical partnerships.
  • Seek out horizontal partnerships.

Strategies for specialists

On the other side of the ditch, the niche players need to:

  • Maintain exclusivity and product/market share.
  • Keep the speciality pure, but create subspecialties as needed.
  • Practise target marketing and avoid segment creep.
  • Offer sales expertise, great personal service, and superior experiences.
  • Shun fixed costs - specialists can slide into the ditch if their cost structure becomes too high.
  • Create entry barriers.
  • Avoid the regional specialist's path.
  • Control growth - resist the temptation to try to become a full-line generalist.

Specialists should avoid lines of business that can be easily ramped up to serve thousands or millions of customers and achieve significant economies of scale. This is the natural terrain of volume-based generalists, and specialists can only achieve short-term success. Specialists should exhibit diseconomies of scale, penalising companies that seek volume-based growth. Growing through more precise market specialisation is a much wiser strategy.

Strategies for the ditch

The way out of the 'Bermuda Triangle of competitive strategy' can be long and possibly fatal. It is far easier to stay out of the ditch in the first place. Companies that fall in are weakened financially or are too small to be full-line players like the top generalist competitors. They are also too big to be focused margin-based specialised players. The ditch thus consists of overgrown niche players and undersized full-line companies, neither of which is viable in the long term.

Specialists often give in to the demands of stakeholders to grow beyond their means. Generalists are pushed into the ditch by their head-to-head competitors. Few companies actually stay in the ditch for very long. Either the firm realises its problems and takes steps to become a niche player (probably the best strategy), or a generalist looking to solidify its position acquires it. Either result beats the alternative, which is simply to declare bankruptcy and expire.

Globalisation and the Rule of Three

The Rule of Three is most common in the United States but it is now occurring more frequently in European and Asian markets, especially in the wake of globalisation. It is particularly evident in the globalisation process. No matter how large the market, the Rule prevails, say the authors. When a market expands (whether from local to regional, regional to national, or national to global), the Rule of Three forces further industry consolidation and restructuring.

In the globalisation process, the number 1 company in each 'triad' market (North America, Western Europe, and Asia) is best positioned to survive as a global full-line generalist. When foreign competition enters, the first casualty is usually the number 3 company, since it is by far the weakest. Without government subsidies, each member of the global Big 3 probably comes from a different region in the triad. To be successful as a global full-line generalist, a company needs to have a major presence in all three areas.

When moving from a domestic Rule of Three to the global level, companies should observe the following rules:

  1. Shore up the domestic market first so you are not vulnerable at home.
  2. The best attack strategy for entering a market is to offer a better product at a lower price, rather than a better product at a premium price.
  3. Counterattack in an attacker's home market.
  4. Time the entry right, eg when domestic players are preoccupied with other issues or just after they have completed a major capital spending programme.
  5. Don't go into foreign markets alone. Form a 'complementary front' with other firms, each segmenting the market and going after different slices of it.

The primary concern for any player, global or local, is to stay out of the ditch. Take a look at your own firm and industry to see if the Rule of Three applies. Where do you stand in relation to the ditch?

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