ch’i and cheng
The Warren Buffett way revisited
Cemeteries are full of companies that didn’t understand the power game.
I still have some difficulty comparing the economic terrain to a battleground because the behaviors are more polite. Nevertheless, in both cases, we seek to access something scarce, a coveted territory. However, if in a war the enemy is identified, the economy does not lend itself to such easy identification. Who is the enemy? What are we trying to take away from him?
From Sun Tzu, chapter 6:
That by which the host of the Three Armies may be made assuredly to receive the enemy but to suffer no defeat is ch’i and cheng…In battle, speaking generally, one use the cheng to engage, the ch’i to gain victory…Battle dynamics do not exceed ch’i and cheng, but the mutations of ch’i and cheng are inexhaustible. Ch’i and cheng give birth to one another. Like the endlessness of a continuing ring-who can exhaust them ?
The ideas of The Art of War are often used as a corporate strategy because the victories obtained in this treaty are psychological above all: the enemy is psychologically defeated before being materially defeated. In the business world, the enemy is increasingly the customer to be conquered (not the competitor to be defeated) and this requires a lot of psychology. Marc Andreessen has a very beautiful image to synthesize the art of selling: you have to sell your product to the customer before the customer sells you that he will not buy it. This image clearly shows that winning the customer is a battle.
The enemy is the customer to be conquered
Let us return to this assertion. The Internet has changed priorities. Until then, the secret of competitive advantage was to control a resource (before others) and to become the mandatory gateway. Of course, it was necessary to be customer oriented, but only to the extent that it made it possible to capture this precious resource. The client was a second order priority. Some companies could even do without it if they had control over access to a natural or intellectual resource: for example, De Beers, oil or pharmaceutical companies. For the others, the objective was to obtain a scale advantage such that competitors would no longer have a chance. Bruce Greenwald and Judd Kahn in their book Competition demystified illustrate the state of mind at the time. According to the authors, Porter's 5 forces are too complicated a scheme to understand competitive advantage. In fact, everything can be summed up as barriers to entry: customers are best seen as a means of eliminating the competition that is the enemy. Let us give some examples: Coca Cola dominates because of its distribution strength, not because the product is better. By seeing a Coca Cola distributor on every street corner, a Coca Cola advertising poster as soon as you lift your nose, you end up assimilating thirst to Coca Cola and this constitutes a serious barrier to entry for any existing and potential competitor. The resource that Coca Cola has appropriated is an inscription in the psyche of every human being, at a cost of billions of dollars. Similarly, the Washington Post was not necessarily a high-quality newspaper but the one that was delivered to Washington residents every morning (thanks to a dominant infrastructure: printing, distribution: fixed costs were the barrier to entry). Warren Buffett often bragged about being safe with the Washington Post because even an idiot could take over the leadership:
If you've got a good enough business, if you have a monopoly newspaper, if you have a network television station - I'm talking of the past - you know, your idiot nephew could run it. And if you've got a really good business, it doesn't make any difference."
or:
I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.
The concept is simple: if you have built a competitive advantage by controlling a scarce resource, whether it is a printing press, a wireless channel, a distribution force, a patent or a prime location (Wal Mart), you can install a toll and count the revenues day after day. This is the Warren Buffett way. Therefore, the strategy is also very simple: to occupy the field before others. In 2000, Warren Buffett's largest investments were: American Express (domination by an integrated payment network), Coca Cola (domination by distribution), Gillette (domination by distribution), the Washington Post (domination by infrastructure over Washington) and Wells Fargo (domination of money flows in California). In 2005, a few companies were added, including Anheuser Busch (scale effect on beer production and transport infrastructure), Petro China (control of oil resources), Wal Mart (control of operations in medium-sized cities and then throughout the United States) and Moody's (registration in the investors' psyche). What we must remember in this pre-internet design is that the enemy is the competitor on whom we must have the upper hand. The term competitive advantage expresses it well. The strategy is not a battle to be fought for the customer but a race to build first the fortress protected by a moat (the famous barriers to entry), which will prevent competitors from having access to this customer. If several people arrive on the finish line (Bruce Greenwald gives the example of the ABC, CBS and NBC television networks), the only solution is to get along. The strategy to adopt is rather that of the prisonner’s dilemma where cooperation prevails over betrayal. The oligopoly is the best solution after the monopoly. All this is not really to the customer's advantage.
The Internet has changed the balance of power. With the reduction of friction, what was scarce became abundant. You no longer have to wait for your newspaper to arrive under your door every morning, just turn on your smartphone. Gillette had managed to control a scarce resource by bludgeoning the inscription in the psyche of billions of human beings that their blades were the only way not to appear scarred and ridiculous in the morning at work. And it was monetizing this very expensive inscription. But today, it is possible to buy from Amazon a batch of blades 4 times cheaper with many positive recommendations from users. The fortress has cracks... The battle has changed in nature. It is now necessary to first convince the clients (they are the ones who provide the assessments) when they have a wealth of information at their disposal. The battle has become fair.
From Business insider, september 28, 2019:
Jeff Bezos shared several views on Amazon at a conference at the Washington Economic Club on September 13.
At the beginning of the presentation, he expanded on Amazon's number one principle of leadership: customer obsession. Business leaders must focus on the customer rather than the competitor, he said.
Mr. Bezos said he looks for this customer obsession when investing in new companies.
Amazon has 14 leadership principles that guide the economic decisions of its employees, but founder Jeff Bezos said only one of them is the "secret sauce" for the success of the trillion-dollar company.
"What made our success by far is the customer's obsession rather than the competitor's," Bezos said in a September 13 speech to the Washington Economic Club.
By focusing on what customers want or need, Amazon has taken the lead on many of Amazon's most profitable business initiatives.
It is important to note at this point that Bruce Greenwald, an economics professor at Columbia, completely missed Apple and regularly predicted its collapse. For him, the customer could only be captured with a product with the following characteristics: repetitive purchase, low unit purchase price. The purchase had to be automatic (the customer is a zombie). The iPhone did not fit into its framework. This vision is largely in line with Warren Buffett's vision, who spoke in Berkshire Hathaway's annual letter to shareholders in 1996 of his "inevitables »:
Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.
For Warren Buffett, once the place in the consumer's imagination has been taken (with billions of dollars invested in distribution), the war is won against competitors for 10, 20 years or more. Since Warren Buffett's letter, the price of Coca Cola has risen by less than 5% per year over the next 23 years, little more than a bond, that of Gillette (now Procter & Gamble) by 8%...and that of Amazon by 36% per year. Didn't Warren Buffet fight the wrong battle ? If the enemy is the customer, not the competitor, he must be defeated by the wow effect rather than persuaded (by bludgeoning), considering that he is an adjustment variable to fight competition. Sun Tzu's The Art of War then becomes a more interesting guide than the traditional technique of accumulating gunpowder to win the battle.
Ch'i and cheng
If the customer is the enemy whose resistance must be overcome, the traditional war of weapons, that of Buffett, Greenwald and Malone, based on economies of scale and customer captivity, is no longer enough. Otherwise, how else can we explain that Facebook with its 30 million users in 2007 managed to eclipse Myspace and its 500 million users, the same for Zoom against Skype and Amazon against Wal Mart?
The principle of traditional warfare is based on Lanchester’s model: it considers two parameters for each army: the number of weapons and their effectiveness. There is a geometric relationship between the two parameters in that to compensate an army twice as large as its enemy's, you need weapons that are 4 times more powerful. This model gives importance to numbers and explains well the wars of the 19th and 20th centuries. Sun Tzu opposed this model before its time (5th century) when he wrote: "number alone does not confer any advantage". His war is based on agility: the ability to direct the fight in such a way as to disorient the enemy, again and again, until he loses his bearings and panics. Ch'i and cheng are the vectors of this strategy: cheng makes it possible to fix the enemy in a "expected" fight while ch'i then takes him by surprise. We can take the example of the Blitzkrieg led by the German armies in 1940 against France: the traditional attack was led in the North by the Netherlands while a second atypical front opened in the Ardennes. It was atypical in that, unlike the battles of the First World War, the Germans did not seek to consolidate their position to attack again, but continued to advance relentlessly creating panic in the French camp. It is the contrast between the traditional (expected) on the northern plains and the innovative (unexpected) in the Ardennes, which has disoriented the French: ch'i cannot be heard without cheng and vice versa. That is why, in the wars of Sun Tzu, ch'i quickly becomes cheng and then it is necessary to invent a new ch'i. Let us recall his words: "The dynamics of combat do not go beyond ch'i and cheng, but the mutations of ch'i and cheng are inexhaustible". The ch'i et cheng concept was taken up in the 1980s by an American fighter pilot named John Boyd who invented the OODA loop (Observe, Orient, Decide, Act), a modern version of ch'i et cheng, inspiring the Pentagon's current strategies...and those of the Internet companies.
The parallel with the business world is instructive: there is the ancient war, based on the race for size (the famous first entrant that scales before the other). Therefore, the competitor to win, not having the numerical superiority, must be much more efficient, cutting his overhead costs as much as possible: the Greenwald war is between size and efficiency effect. There was no room, when he wrote his book for Amazon or Apple. Certainly, Warren Buffett has widely criticized the search for size for size, citing the fable of the frog and the ox. But his criticism is still based on the traditional war logic: 1/ size is not a sufficient condition to capture a precious resource, 2/ it can generate bureaucracy, thus reducing efficiency, 3/ when size is overpaid by acquisition, there is a loss of financial resources to fight the battle.
Observation: the key to winning the consumer
Internet companies in the 2000s had no choice but to change the rules of the game. Being small in size, the traditional strategy would have been to differentiate/distinguish/win by lower costs, i.e. more efficiency. Many have precisely minimized Internet companies by considering only the cost advantages they could bring. Confusion with Geico's business model was easy:
Geico is an insurance company with a direct model (by telephone before the Internet). Its advantage lies in low overheads and a combined ratio that is 4% lower than its competitors selling through a network of agents. The advantage is in efficiency.
Geico is one of Warren Buffett's favorite investments, as it was with his mentor Benjamin Graham.
Geico is a very good investment.
However, the Internet goes well beyond the telephone and the reduction of overhead costs, it allows observation, the sine qua non condition of ch'i and cheng. Ch'i and cheng are indeed not only inseparable but also inexhaustible in their variations (it is difficult to admit for a fan of stability as Warren Buffett is). You have to be able to direct the fight to disorient the other, so always know the state of the opposing troops, that's the key. As soon as the opponent has regained his landmarks having cashed the ch'i, the latter must be transformed into a cheng to develop a new ch'i. Observation is at the heart of the strategy, as in the OODA loop.
With the Internet came cookies, small text files sent by websites to users' computers and stored in the browser (Netscape was the pioneer of technology since 1996). These cookies made it possible to observe the user's behaviour, first on a particular site and then on all the sites visited by the user. From then on, it became easier for a website to know the user's preferences, to give him what he expected (cheng) to better surprise him (by ch' i). The major Internet media have far surpassed the effectiveness of the cookie: by asking their users to connect to their universe, and by promoting interactions, they have a higher level of information, without having to justify themselves at each connection ( This is why the RGPD is a gift to Google and Facebook). The best companies to conduct a ch'i and cheng war are the internet companies that force their users to connect, first Google, Facebook, Amazon, etc.
How Internet companies use ch'i and cheng
Internet companies are not the first to think ch'i and cheng. Apple is a striking illustration of the use of this technique, especially in the days of Steve Jobs who had the art of anticipating customer needs. From 1999, date of Apple's rebirth, each Keynote ended with: "One more thing... The first part of the Keynote was devoted to what the client expected (cheng) and the second part to what should surprise him (ch'i). The customer had the impression to be overwhelmed with each Keynote, the ch'i became then the new cheng and Apple had to surpass itself once again. This is how Apple's Keynote has become a global event and Apple one of the most valued brands in the world.
The major Internet media, thanks to their targeting, know with a reasonable probability the intentions of their users. It is therefore easy for them to calibrate cheng, i.e. to meet their expectations: this is what Google is doing better and better with its search engine or Netflix with its recommendation algorithm. But these companies are octopuses and that is what makes them strong. In 2004, Google launched Gmail, an unexpected service (ch'i). What does this have to do with research? Gmail delighted its users with a high level of fluidity, unusual for messaging, and huge storage capacity. Gmail now has more than 1.5 billion active users. Gmail was for Google a way to better identify users than with cookies, an additional observation post to conduct the war of ch'i and cheng. In 2005, Google acquired Android for $50 million, a rather unexpected move aimed at imposing the search engine on the smartphone and then the Google Play Store and its many Google applications: Map, Earth, Translate, Lens, etc. Android, ch'i initially became cheng for these applications (ch'i). Now, each Google application is derived in ch'i and cheng. For example, Map constantly offers unexpected features (for example, augmented reality today). The ch'i usually provides additional information to correct the observation and start a new ch'i/cheng round or OODA loop.
Ch'i and cheng are used to distinguish high quality companies
An old-fashioned internet business can be a good investment. Geico, for example, always does the same thing (car insurance) more efficiently than its competitors, who are burdened by their commercial network, and it works. Warren Buffett praises both Geico's profitability and growth. Here is what he says in his 2018 letter to shareholders:
GEICO is now the second largest motor insurer in the United States, with sales 1,200% higher than those recorded in 1995. Subscription income has totalled $15.5B (before taxes) since our purchase, and the float available for investment has increased from $2.5B to $22.1B.
By my estimates, Tony's management of GEICO has increased Berkshire's intrinsic value by more than $50 billion.
Warren Buffett estimates Geico's intrinsic value at just over $50 billion, a pretty good amount after 68 years of investment, but Alphabet, Amazon or Facebook are worth between 5 and 10 times more and it took less than 20 years.
An Internet business, to flourish today, must master the art of ch'i and cheng and hold the customer like an octopus. Otherwise, it may suddenly be overtaken by a more sprawling actor or one who is even more attentive to the customer. Isn't that the risk for Slack, who has designed an enterprise application that is very suitable for collaboration, but is being copied and caught up by Teams, an application integrated into the Microsoft universe? What will Slack do to win over the customer who is tempted by the simplicity of an integrated offer? Business applications (OKTA, MongoDB, Dropbox, etc.) are particularly threatened because they have been able to distinguish themselves on a particular function that becomes cheng and they must continue to win over the customer through the subtle interplay of ch'i and cheng. The risk is that the customer will sell them that he will no longer adopt their solution.
So when we analyze an Internet company, or even any type of company simply because the Internet is inevitable, it is interesting to ask whether it masters Sun Tzu's art of war or whether it has a more traditional strategy (nowadays a greater risk because the customer has woken up). Netflix, for example, practiced ch'i and cheng extensively in the 2000s, allowing it to get rid of Blockbuster. But now that Netflix offers all the series imaginable (cheng), what will it reserve as a surprise to win the spectator subjected to an increasingly varied streaming offer?
In the "as a service" economy as it spreads everywhere, nothing is owned, everything is hired... and easily. Controlling a scarce resource becomes a challenge. If we can find it, that's fine, but we really need to make sure it's exclusive. In uncertainty, the advantage will be given to the one who masters ch'i and cheng, it is this ability that must be discerned.
Ch'i cannot do without cheng
That's Star Wars' lesson. The franchise has been declining for several years. Episode VII had been a great success with a $2 billion box office, Star Wars story: Rogue One collected $1 billion, episode VIII $1.33 billion and Star Wars story: Solo only made $400 million in revenue. Franchises to renew the enthusiasm of their fans try to surprise, but if they no longer meet their expectations, their support base erodes until the franchise is forgotten. If episode VII lacked a little ch'i, being considered too pastiche of the previous 6 episodes, episode VIII, however surprising it may be, completely disappointed the expectations of fans (cheng). After the long and tedious search for Luke Skywalker in episode VII, we discover him disillusioned in episode VIII, determined not to fight and his mind tortured throughout the film. All this has pushed the fan club back. This is an excellent lesson for warfare according to Sun Tzu: ch'i and cheng can be a formidable positive spiral, but if the balance between the two derails, the descent is rapid. This is why even within the same group (Disney in this case), some franchises have positive dynamics (Iron Man, Avengers) while others are sinking (Star wars, X men) without really understanding why. In fact, an imbalance in ch'i and cheng quickly derails a franchise.
The master of ch'i and cheng: Amazon
Amazon started as an online bookstore. The customer's expectations were to be delivered quickly, to which Amazon responded very well (cheng). Ch'i has been the return policy. Contrary to what was usually done in mail order, Amazon would send the ordered book back without asking for a return at the slightest problem. This costly approach for Amazon immediately gave it goodwill. Then this ch'i became cheng and Amazon found a new ch'i: the extension of its offer. Amazon provided abundance, an almost infinite number of products when it seemed difficult to do better than Wal Mart. Then abundance became an ordinary expectation, a cheng and Amazon began to fight over delivery times: in 2005, the company announced the creation of Amazon Prime, a subscription to a guaranteed two-day delivery service in the United States. We could multiply the manifestations of ch'i and cheng deployed to infinity by Amazon, the interesting thing is that the company has institutionalized this practice in its culture:
Amazon was built on the observation of customer needs. Jeff Bezos is a former quant, obsessed with data mining.
At Amazon, everyone is a customer, even employees! Amazon is structured around small teams that interact with each other in a customer/supplier relationship. This has the advantage of establishing ch'i and cheng at all levels and thus multiplying its potential manifestations. Each team is a start up that works for the others (first customers). This is what Jeff Bezos would have asked for in 2002:
All teams will now expose their data and functionality through service interfaces.
Teams must communicate with each other through these interfaces.
There will be no other form of communication between teams allowed: no direct link, no direct reading from another team's database, no shared memory model, no back-doors. The only communication allowed is through service interface calls on the network.
No matter what technology they use.
All service interfaces, without exception, must be designed from the outset to be outsourced. That is, the team must plan and design to be able to expose the interface to developers from the outside world. No exceptions.
To encourage the emergence of ch'i and cheng, Amazon instituted the memo (2004): each start up thus constituted (and there are more and more in a company with more than 500,000 employees growing by 20% per year) must develop its ch'i ideas from a memo which is then presented to the management. The power point is prohibited because it is too blurry. For Jeff Bezos, what is well conceived is clearly stated. The memo encourages to consider the whole problem and its joints. It is individual, therefore ideal to promote the expression of creativity. The group is used to sort ideas, potentially very numerous and to amplify them when they are good: this gives ch'i on a large scale like Prime, Go, AWS, Logistic, etc.
In short, Amazon is a machine that generates ch'i and cheng at all levels of its organization, a unique type of company that cannot be classified by traditional standards. Of course, there can be failures, acceptance of it is even encouraged in Amazon's culture, but ch'i and cheng are constantly regenerating.
The ever-changing octopuses of the Internet are far from Warren Buffett's stable businesses. Their economic model is new and difficult to understand in the traditional logic of competitive advantage. When these groups manage to institutionalize ch'i and cheng in their culture, as Amazon does, they then hold a new resource: the entire user, a proprietary resource in the traditional sense. That's when Warren Buffett finally feel at home with this kind of business... Apple represents one of his most important positions. But the brands that Apple, Google or Microsoft have become do not protect them against an imbalance of ch'i and cheng. This is not the kind of company that a stupid nephew of Warren Buffett could run.