Monday, January 14, 2019

The Myth of Capitalism: Monopolies and the Death of Competition. Jonathan Tepper and Denise Hearn. A review...

The Myth of Capitalism is a polemic about the reduction in competition in many industries in the US. And it starts in an entirely appropriate place.

Dr Dao - a doctor with patients to serve the next day - was "selected" by United Airlines to be removed from an overbooked plane.

As he had patients to tend the next day he did not think he should leave the plane. So the airline sent thugs to bash him up and forcibly removed him.

The video (truly sickening) went viral. But the airline did not apologise. The problem it seems was caused by customer intransigence. 

They apologised after what Tepper and Hearn think was true public revolt, but what I think was more likely the realistic threat to ban United Airlines from China because of the racial undertones underlying that incident.

If a "normal" company sent thugs to brutalise its customers it would go out of business. But United went from strength to strength.

The reason the authors assert was that United has so much market power you have no choice to fly them anyway - and by demonstrating they had the power to kick your teeth in they also demonstrated that they had the power to raise prices. The stock went up pretty sharply in the end.

Oligopoly - extreme market power - not only makes airlines super-profitable. It gives them the licence to behave like complete jerks. 

But what is true of airlines is true of industry after industry in the United States. Hospital mergers have left many towns with one or two hospitals. Health insurance is consolidated to the point where in most states there is only one or two realistic choices. Even the chicken-farming industry is consolidated to the point where the relatively unskilled and non-technical industry makes super-normal profits. Tepper and Hearn have assembled many other examples.

Two other assertions lace this book. Firstly - and somewhat controversially - the authors assert that low levels of competition lead to low levels of innovation (and hence lower levels of economic growth). This is controversial because Silicon Valley produces companies with very little competition (Google for example) that are clearly innovative.

The second assertion is that companies with market power use their power both ways - firstly to raise prices to customers, but just as importantly to squeeze suppliers, especially employees.

Oligopoly and innovation

Peter Thiel (one of the anti-heroes of this book) has long argued that market power and super-normal profits are the goal of innovation and that innovative firms innovate to keep the good times rolling. And indeed this is part of the model of Silicon Valley. Thiel's receives consistent support from economists who receive sponsorship/grants/work from monopolists. Tepper suggests that these economists might be compared to prostitutes - except that would be grossly unfair to prostitutes. 

I am going to add my two-bits worth here. Thiel is almost certainly right in Silicon Valley. Innovation is both the source of and funded by high-levels of market power.

But Thiel is wrong in much of the world. I live in Australia - the land of oligopolies. The Sydney business community is possibly the most conservative business community that size in the world. If you are a businessman here your job is to (largely) to milk the excessive market power that your business has in what is a small and isolated market. Disruption is to be feared and discouraged because it is a threat to the gravy train. This differs a lot from Thiel's world - but I suspect that in many industries oligopolists are innovation phobic. 

Oligopoly and suppliers

Perhaps the biggest contribution this book makes to the policy debate is to examine how market power is used to squeeze suppliers and not just customers. This is - in the authors view - why in this cycle wages have not risen as the economy comes close to full employment. They just think that monopsony employers squeeze wages. They do because of market power - and because of unfair clauses in employment contracts like non-compete clauses. There is an argument for non-compete clauses where staff could walk with intellectual property - but the book notes widespread non-compete clauses in the fast food industry. A non-compete for flipping burgers is just a mechanism that allows employers to suppress wages.

Tepper and Hearn note that wage growth is slower in areas with few employment choices (especially areas with just one large employer in town). The rural-urban wage divide in America is - the author argue - exacerbated by this. 

When you interview Trump voters in rural areas about why they voted for Trump they often state that they think the system is rigged against them. Tepper and Hearn argue that is because the system really is rigged against them.

Low prices and oligopoly

There is a form of American industry that doesn't try to raise prices. Amazon, Costco and above all WalMart are the key example.

Walmart for years used to talk in their conference calls about all the cost savings they were implementing. And analysts would want to put those cost savings into their model as earnings. Walmart would disabuse you of this. Cost savings are passed to customers

By doing this Walmart squeezed competitors until in many places it is the only local supplier of note. But it did this by the pro-market tactic of lower prices.

This doesn't look supportive of the Tepper/Hearn thesis - except that they argue that Walmart and Amazon (but to a much lesser extent Costco) then use the considerable market power they accrue to squeeze their suppliers (especially their workers). Walmart famously pays low wages. Amazon uses veritable armies of lowly paid contractors. 

Market power gives licence to corporate management to behave like jerks, whether it be kicking in the teeth of their customers (United Airways) or paying their workers poverty wages (Walmart).

The Costco counter-example

Costco is almost the only company in this book that comes off well. Sure they win by having lower prices - but they also win by having well paid and happier workers (and much lower staff turnover). Costco management are not jerks. And in that they provide a decent counterexample to management described throughout this book.

But even Costco squeezes suppliers. This example is recent and not in the book. Costco is entering the business of breeding chickens for meat - and it is doing it in a spectacularly large way. Obviously this is not core business. But they came up against the chicken meat oligopoly (discussed in the book) and Costco thought they would win by disrupting their oligopolistic suppliers.

An angry book is not much use to me

Tepper and Hearn have written an angry book. It is angry at the regulators that have allowed non-competitive mergers to happen. It is angry at politicians and lobbyists in the pocket of supernormally profitable corporations.

The solution to the problem in capitalism according to the authors is more capitalism. They want more entrepreneurism, less barriers to entry in companies but also they want regulators to view skeptically (and stop) anti-competitive mergers. They endorse measures against tech companies that stop them leveraging monopolies on one sector into monopolies in another sector. They would have endorsed the break-up of Microsoft into an operating system company and an applications company.

They provide a reasonable agenda for a market-friendly politician or regulator who believes in competition and doesn't want to be on the lobbyist tit. 

All well and good but I have no use for their anger. I am not a regulator or a lobbyist or a politician. And there are plenty of other things in the world to be angry about. 

But that doesn't mean I regret reading the book. I don't. I am a hedge fund manager and my job is to make money for my clients. 

And the simple question I ask about a book like this is "will it help me make money for my clients".

In this case the answer is yes. 

It gave me a few direct clues on how to make money. But I am not going to tell you those. Read the book. 

But it also gave me some useful analytical tools which I will use fairly regularly. That I demonstrate by example.

French fries and (economic) freedom

Lamb Weston - the world's biggest marker of french fries is a minor obsession of mine. Margins have crept up and are now over 17 percent. If you go back 20 years (well before the company was spun out of Conagra) the company business faced gluts and made losses. 

Profitability has been rising for years. Operating margins are now two thirds of Apple. But Apple do cool sophisticated and expensive stuff for those margins. Lamb Weston processes and distributes potatoes.

The business used to be cyclic. There is an article in the New York Times in 1997 about about a glut laying waste to the industry. 

But it doesn't look like that now - and it hasn't for years. 

The market values Lamb Weston at 3.4 times sales. [Ratio is (net debt + market cap)/revenue.]

By contrast Apple - a company that has huge market power and very fat margins - is valued at 2.9 times sales.

To me this looks absurd. The market values wholesale sales of french fries considerably higher than it values Apple's sales.

Apple does a huge amount for its sales. They develop and manufacture sophisticated and groovy devices with sophisticated software. They have redefined corporate cool. And they smell hyper-profitable.

Except that buying potatoes cutting them into french fries, par cooking them, freezing them and distributing them to fast-food chains is valued more highly by the market. (Again my measure is EV to sales but this is true by most measures...)

And it is not as if french fries are high growth either. They grow low single digit - and there are good reasons (mostly health) as to why that should slow too. 

I have to ask myself why shouldn't I short Lamb Weston. Surely competition is going to rip those margins lower at some point.

Tepper and Hearn provide one explanation as to why I should not put on the obvious trade - oligopoly.

And it is pretty clear that they are right. French fries is a super-profitable business.

In conference calls Lamb Weston signal extremely modest expansions in capacity. It is like the many companies who signal in conference calls that they are happy with their market share. They are of course signalling that they are not interested in a price war.

Of course an oligopoly is vulnerable if someone well funded wants to enter the industry. And in a country with true economic freedom that shouldn't he hard. There isn't anything spectacularly technical about making french fries.

That the margin has stayed this high (and indeed grown) is a signal of a lack of economic freedom. Nobody seems able or willing to break the french fry oligopoly - and that has to be in some sense political.

We shouldn't call them "freedom fries". May I propose "economic oppression fries". It seems more accurate.

The politics of the french fry oligopoly

French fries it seems are absurdly profitable. The return on assets is in the teens (which seems kind-of-good in this low return world). Margins keep rising and yet there is no obvious emerging competition.

It may be a good investment even though it looks pretty expensive. But if competition comes Lamb Weston could be a terrible stock.

There has been plenty of consolidation in this industry. Sure many of the mergers shouldn't have been approved by regulators - but they were - and the industry has become oligopolistic.

But this is not a complicated industry - it is not obvious why competition doesn't come. 

Bluntly I really don't have a clue what keeps the competition out.

It could be regulation (and captured regulators). It might be the farmers don't want further entries.

Whatever there is not much policy ground for lowering the cost of french fries. They don't exactly meet public health objectives.

Tepper and Hearn would argue that the oligopoly is used to suppress payments to suppliers - and the main supplier here are Idaho farmers. Usually they would be pretty good at lobbying. But there is another possibility - which is that the oligopoly is super-strong - and some of the excess profits are used to pay over-market prices to the farmers and 
maybe the farmers have (in their own interest) chosen to lock up the industry with regulation (and lobbying).

This is the sort of thing that is never spelled out in the accounts. After all if the company makes its profits by screwing the public it isn't going to tell you. [Unless they are United Airways who are just jerks.]

So without a detailed knowledge of the politics of rural Idaho I can't really analyse this situation. But hey - after reading this rather good book I know the questions to ask.

If anyone is really familiar with this oligopoly (particularly any potato farmers) I would really love to talk to you.

Till then I will just try to find another interesting book to read.


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