One of the most remarkable moments of a century-old war for market share occurred in 1974 when Pepsi (NASDAQ:PEP) first launched its Pepsi Challenge against Coca-Cola (NYSE:KO).

According to Bruce Greenwald and Judd Kahn in chapter nine of “Competition Demystified: A Radically Simplified Approach to Business Strategy,” a local Pepsi sales manager in Dallas first offered supermarket customers a blind taste test. As we all know, Pepsi, which was a bit sweeter, outgunned Coke, especially among younger customers.

In offering the taste test, Pepsi wasn’t taking on much risk; previous research had shown a big margin in its favor, 58% versus 42% for Coke. The promotion was expanded in 1975 and by 1976 had gone national, allowing it to capture a significant amount of market share in food store sales.

Both beverages began in much the same way, with formulas concocted by pharmacists in southern U.S. cities in the latter years of the 19th century. Both began as counter treats in individual drug stores and each gained enough popularity to expand throughout the country. In the first half of the 20th century, though, Coca-Cola enjoyed good management; Pepsi did not. The result was that Coke had much more market share.PEP 30-Year Financial DataThe intrinsic value of PEPPeter Lynch Chart of PEP

Pepsi’s fortunes began to turn around in 1950 when Alfred Steele became its CEO. During the 1950s and beyond, Pepsi aggressively chased market share. Coca-Cola responded by ignoring it all, to its own detriment. That inaction took a toll; at the end of World War II, Coca-Cola had 70% of the market but by 1966 it was reduced to 30% share while Pepsi had 20%.

Coca-Cola finally responded in 1977—by shooting itself in the foot. According to Greenwald and Kahn, it set off a price war to try to gain, or regain, market share. Both companies suffered financially, but the authors pointed out that Coca-Cola lost four dollars for every dollar lost by Pepsi.

The second initiative by Coca-Cola seemed to be just as bad. In 1985 it introduced a sweeter version of its original formula, under the name of New Coke and stopped producing the original. The initiative has since become a classic case of bad marketing as many existing customers were outraged to lose their favorite beverage and sales fell dramatically. Just a few months later, Coca-Cola was forced to reverse itself, bringing back the original as Coca-Cola Classic while maintaining the new formulation as New Coke.

But there was a silver lining in this debacle. Coca-Cola now had a product with which to attack Pepsi; its sweeter new version appealed to the youth market that Pepsi had dominated for years. As the authors put it, New Coke could be employed as an “attack” brand. It was estimated that if New Coke were used this way it might capture one-sixth of Pepsi’s market share. And if it used New Coke as a low-priced, warrior brand, Pepsi would lose six dollars for every dollar Coca-Cola lost. What’s more, Coca-Cola Classic would not be involved and could continue delivering high-profit margins. Coca-Cola had finally learned how to fight back.

While Coca-Cola might have exploited its new advantage, it could no longer afford to chase market share at the expense of the bottom line. It had undergone a major corporate reorganization that involved buying many of its bottlers and putting them into a spin-off called Coca-Cola Enterprises (CCET). Because this involved a lot of debt and debt repayment, the company now had to focus on cash flow.

Pepsi, too, recognized not only the threat of New Coke, but also Coca-Cola’s new financial priorities. It quit running the Pepsi Challenges and toned down its aggressive advertising, both of which signaled it too was ready for peace.

Another factor was that both companies were, as of 1986, headed by CEOs who favored profitability over bragging rights. Robert Goizueta, the authors told us, had two key measures, return on equity and the share price. As for revenue (a reflection of market share), Goizueta considered it “the curse of all curses,” By this time, Warren Buffett (Trades, Portfolio) was also on the Coca-Cola board, and as Greenwald and Kahn expressed it, provided his “statesmanlike” support for Goizueta.

Wayne Calloway at PepsiCo (Pepsi's new name by this time) also favored profits over market share, and during the decade when their terms overlapped, between 1986 and 1996, both companies enjoyed strong growth in their stock prices.

Both Calloway and Goizueta died of cancer, the former in 1996 and the latter in 1997, and following their deaths, both companies appointed “Cola Warriors” as CEOs. Both wanted to resume the fight for market share, but neither lasted long; Douglas Ivester at Coca-Cola was gone after just two years. Roger Enrico at PepsiCo was CEO for five years, from 1996 until his retirement in 2001.

The prisoner’s dilemma has played an important role in Greenwald and Kahn’s analysis of competition between big players with competitive advantages. The prisoner’s dilemma refers to a scenario in which two criminals are arrested and kept in separate cells. If neither criminal confesses and implicates the other, both will likely walk free. But if one gives in and confesses to police, both will go to jail; the one who confesses will get a lighter sentence and the one who does not will get a heavier sentence. As the authors explained, there may be rewards for both criminals to not confess, but those rewards may be overwhelmed by the incentive to cheat.

Consumers may like price wars, but investors prefer peace where all parties earn strong returns. We certainly know that Buffett does and no doubt he was a strong voice for an end to the battle for market share. As we saw, both Coca-Cola and Pepsi played the role of confessing criminals between 1950 and 1985, and both paid a price in lower returns. With the introduction of New Coke, though, both companies knew that following that path would lead to the mutual destruction of their bottom lines and opted for cooperation over aggressive competition.

Conclusion

In their book “Competition Demystified: A Radically Simplified Approach to Business Strategy,” Greenwald and Kahn argued that companies with competitive advantages must work to preserve their leadership positions. One of the analytical tools they use to understand, reinforce and protect those advantages is the prisoner’s dilemma game.

In chapter nine, we saw how the Cola Wars could be assessed in these terms. For three and a half decades, neither company saw any value in ending the fight for market share, a fight that had depressed bottom lines on both sides. However, the emergence of mutual deterrents, as well as a change in corporate cultures, eventually led to cooperation.

Investors will find the dynamics of this rivalry of value when they assess the strength of competitive advantages in the companies they are researching.

Disclaimer: This review is based on the book, “Competition Demystified: A Radically Simplified Approach to Business Strategy” by Bruce Greenwald and Judd Kahn, published in 2005 by Portfolio/Penguin Group. Unless otherwise noted, all ideas and opinions in these reviews are those of the authors.

Read more here:Competition Demystified: Lowe’s, Home Depot and the Prisoner’s DilemmaCompetition Demystified: Economies of ScaleCompetition Demystified: Advantages in Supply and Demand

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Robert Abbott Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

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