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.



Adam said...

The wealthiest man in Idaho runs an MLM, and the second wealthiest is the head of JR Simplot.

For 12 years, the governor was a former son-in-law of Simplot.

I think most of the other facts you could learn about the internal politics of Idaho will rhyme with these kinds of things.

HSNYC said...

The frozen potato market has always fascinated me. I imagine having two private companies involved helps any oligopoly. To enter you would probably need to achieve a certain immediate scale from a cost perspective and because a lot of the output is sold to very large international buyers. That is hard, but not impossible. The problem is that you would have to lock up a large supply of potatoes from one of the most conservative groups in existence: Idaho farmers. You would have to overpay to get there. I'm certain the established players would find ways to punish the few "liberal" farmers out there that took a risk. McDonald's would probably do this if it was run by Bezos. But it is not and they are not competitively disadvantaged so it's not hurting them.

Robert in Chicago said...

One of equity-investing's important and persistent questions that is impossible to answer with certainty is, why are the S&P 500's profit margins sustaining at all-time highs above 12%, versus a long-term average of 8%? Most of the reasons I read don't make sense to me, other than companies' much-increased ability to use cheap labor from emerging markets. Even with that one -- it's a cost-cutting measure that's available to absolutely anyone at scale, and those usually get competed away over time. Why not this time?

Increased market concentration has to be a big part of the answer.

A counter, though, is that a shift in industry mix across the economy probably accounts for at least as much of the increased concentration as does captured/lazy/stupid regulators. Software, e-commerce, social-media, etc., are all industries that lend themselves to natural monopolies or at least natural oligopolies. Those industries either didn't exist 30 years ago or were tiny relative to today.

dearieme said...

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

For the USA I simply assume that virtually all their politicians are corrupt - and often rather cheap to buy - and that it's also true of many of their courts. I take it that their regulatory agencies are corrupt too: why would they not be?

When people voted for that sleazy fellow Trump on the grounds that he was palpably less corrupt than Clinton it should have given people pause for thought.

Anonymous said...

I'm never sure what is being said when people say "more capitalism" or "monopolies prove capitalism doesn't work/is bad", etc.

The "Father of Capitalism" (as a scholarly study), Adam Smith, filled up pages about monopolies and how the government (YES! Adam Smith advocated government regulation!), must skillfully make the rules in the marketplace. Regulating (e.g. monopolies) is a prerequisite for effective, free markets (moral behavior helps too- see another Smith masterpiece: "...Moral Sentiments...".

So, the reason we have gotten into these problems, (that you have skillfully described), is that the government (and the voting public) have not applied government regulation carefully. The remedies are well known, and have been used successfully in the past (looking at it from the point of view of the public; the monopolists didn't like it.) It's time to go "back to the future" and put small, sensible regulations in place (that we already have shown will work!).

United Airlines incident. First, my family has been in aviation for decades, and United has exactly this reputation- brutish. Now, in fact, what happened was completely legal based on the laws around aviation. Also, I heard the Dr./passenger did some other things that made the United staff people suspicious of his behavior. Whenever you see something like this, be assured that there's more there than gets into the popular media.

David said...

Having worked in the construction industry, on the design side, both in a middle size french town and in Sydney, i can agree that the difference in level of competition between both countries is impressive, as well as the technological gap ( in agreement with some more experienced Brit colleagues, a good estimate would be c. 20 years).
The tradies are payed 4 times as much for what could be argued to be a lower quality of work.
Despite this, Sydney homes DO find clients for properties that on most fundamental basis are of a lower quality.
The explanation i can find for this is the premium for safety and wealth protection for the super rich, as well as the concentration of people in large cities and very high skilled and/or cashed up immigration to those cities. This is the big picture.
Monopolies, no monopolies, it is but a side show.

Unknown said...

Maybe it's the combination of lamb AND fries that keeps margins so high?

Anonymous said...

I work in a small company (~25 people) that does niche white collar work. We spend roughly 10-20% of revenues on contracting and accounting. We have to do some fairly interesting legal gyrations and have a couple of different sub LLCs in order to get through contracting and supplier onboarding with large companies. This isn't all voluntary on their part - various regulations require them to send OSHA, conflict diamond (?), FCPA, a whole host of state and local rules, compliance to their suppliers as well. And that's easy relative to negotiating a deal with a government entity, which is a year+ commitment and easily costs $50-100k in internal staff and external legal before we see a dime (add prevailing wage rule and certifications, various diversity and inclusion reporting, anti-bribery stipulations, paternity/maternity leave and various PTO requirements which we have but each one requires hours to determine the precise regulations and then provide the relevant internal policy documents, volunteer hour reporting, carbon emissions, etc). We're high enough margin to float that $50k+ but most small companies are not. Generally only big companies can absorb the costs of dealing with either the government or with other big companies.

My sister runs a small business in one of the big west coast cities. The most profitable part of her business is run more or less off the books and without the proper permitting. It's incredibly expensive to get the necessary permits, takes years, and the only entities who do so are large and well known. The business in question does not pose meaningful health and safety risk to the public (not vaccine production). As a result she's unable to grow the business as she can't get outside capital.

My guess is that if you wanted to compete in the potato business, you'd need tens of millions in capital. There would be a long list of permits from state and federal agencies that take years to get, not to mention there's no way to determine in advance what those permits are, what the cost is, if they are attainable, and how long. Then after 4-5 years, you'd be ready to start the developing your plant. You'd then have to get in front of large, risk averse buyers with extraordinarily complex processes and who have no interest in a small scale producer. Does this sound appealing? I'd rather fund an app for delivering wine by bike courier.

The combination of right wing corporatism and left wing bureaucratic policies have rendered America internally noncompetitive in many senses of the word. You cannot build houses (or much of anything else) in much west coast, not because of insufficient capital - it's fabulously rich - but because of stifling rules and regulation. I don't know if this will all continue forever, or at least for my lifetime, or not. That's a speculative question that if answered right will make you rich. But if the authors are angry, it's for good reason. Were I a fund manager I might be concerned that the present sunshine may not last when millennials inevitably take over from boomers as the largest voting group.

Conscience of a Conservative said...

I love this post. You're preaching to the choir here. Once an industry becomes an oligopoloy we no longer have an efficient market and all sorts of ills follow. Somehow in the United States we've permitted the formation and its now only hurting price competition but product choices and worker employer relationships

Unknown said...

Of course, there is a reduction in competition, because all companies want to be the sole entity that claims ownership of any designated market. Once you hold the monopoly you can act as you wish as there is no own to stop them. And consolidation of a market is mere centralisation, Marx covered this to a great extent long ago.

Low levels of competition lead to low levels of innovation? What have these two moronic authours been smoking?
Innovation arises not from the desire to compete with other companies, it is derived from the desire of the owners to put other businesses out of the market to capitalise and monopolise it for themselves, including creating a smaller workforce and a higher profit margin.
Of course, the farm owners want the market locked, its how they maintain their own monopoly.

If you want a GOOD book to read that will actually enlighten you about the world of capitalist economics I suggest you read Marx.

And in reference to Mr Anonymous' claim that Adam Smith is the Godfather of Capitalism; Pah! You know not of what you speak.

Anonymous said...

Dr. Dao, who you claim had patients to serve the next day, was convicted of trading drugs for gay sex. So, to portray him as some harmless Chinese do-gooder is really disingenuous. But really who would want to fly with a maniac who acts like a child simply because he is bumped from a flight. Guess what, doctors, like Dao, can reschedule their sex patients for another day, normal law-abiding ethical doctors actually do this all the time! This was not some targeted racist event by United. He was randomly selected and no one would care about this if he was a white Republican, but because he's a foreigner and gay...INSTANT HERO!

James said...

I find your Pontius Pilate line about not having any use for the book's anger, you've got money to make, indicates that you too are one of the jerks.

Anonymous said...

"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."

Microsoft ability to leverage its monopoly in another sector has been limited by regulators forcing MS to ask user which browser they want to install (first choice has to be a competitor) during the installation of Windows OS.

From this point of view Regulator has a lot of leverage that could be applied agaist Google/Apple/Amazon

Anonymous said...

I have to believe that a large part of the potato processing question is that it's a *two-sided* oligopoly: not only are there few processors, but there are few intermediate buyers (foodservice distributors, etc.) and a new entrant would have grave difficulty supplying enough product, while meeting both government and contractual quality requirements, at a low enough price to be worth it for a major customer to risk changing suppliers.

Anonymous said...

I am an investment manager who has been long Lamb Weston since the spin from ConAgra. I have met with both management and suppliers. I'm surprised people are talking about Idaho. The Columbia growing area in the state of Washington is the key to Lamb's profitability. It is the most fertile growing area in the world for potatoes, with exceptionally high yielding potatoes. The 3 companies that operate in that area include Lamb and its 2 principal (but smaller) competitors. Lamb is, according to the grower's cooperative, far more sophisticated in its understanding of the economics of the growers, because it grows 25% of its own supply (it is the only manufacturer that has any degree of vertical integration). This supply is critical - besides giving them a direct view of each crop's yield potential, they can also push back against any attempt by growers to negotiate a greater spread for the grower - this owned product is an implicit threat that they would rather not have to use (but could, and this keeps costs under control and allows capex-driven productivity to drive higher margins over time). Given the power that Lamb has in this growing area, as well as the fact that company executives live side-by-side with the growers that supply them, there is a tendency to cooperate rather than be in conflict - while Lamb may hold most of the cards, Lamb's continued success is good for everyone in the community, and no one is incentivized to rock the boat (or kill the golden goose). Happy to discuss further - I initially viewed Lamb as an interesting event-driven spin-off that we would trade, but the more work I did, the more I found this to be a unique opportunity, one with strong demand (people don't just eat fries, they now eat waffle fries, and truffle fries, and curley fries, etc), unusual strength in sourcing (internal and external), market strength (they are a critical supplier to global QSR's), and good returns on capital.

HSNYC said...

To Anonymous investment manager: Because when people think of Idaho they think of potatoes and not much else.

Have you looked into the United Potato Growers CoOp and their relationship with the processors:
I bet there is more to this story than what was reported:

It seems that historically the contracts with farmers have been negotiated through some of these organization (like UPG or SIPCO) and it seems like all three of the producers have had an MFN clause (at least as it relates to the other processors, and probably as it relates to everyone else). Lamb's vertical integration might help them understand what fair pricing might be, but I doubt it gives them an edge at the end of the day. On the other hand, it is massive edge vs an upstart competitor.

Anonymous said...

"Dr. Dao, who you claim had patients to serve the next day, was convicted of trading drugs for gay sex....."

Your criticism seems out of place in this forum. But to act as devils advocate, regardless of whether he was a gay Vietnamese mass murderer with a penchant for eating his victims livers, United did not have the right to bump a passenger with an assigned seat. Once he is sitting down they are sh*t out of luck from an FAA regulations standpoint. What they wanted to do was get one of their staff to the right location. They could have bought a seat from another airline. They dont have to call the airport police to illegally drag a passenger from a seat he had bought and paid for, knocking his teeth out in the process. On video. I didnt follow how much United paid in any settlement. But that might be quite a good index of right or wrong on this issue.

Just my two cents worth.

Anonymous said...

Sounds like it could be similar to Trustpower and the entwined relationship they have with the Tauranga community Trust in NZ. There are cheaper electricity retailer options available to residents but Trustpower has a stranglehold on the local market as its dividend payments get distributed to the local community who are Trustpower customers.

Anonymous said...

The problem with capitalism is the profit motive. If you have investors thats all they care about, you can convince them to wait for a bigger payout but in the end you have to pay that piper. Proponents of capitalism say this profit motive is what drives innovation and efficiency, I argue that while this may be the case it comes after the options of increased prices and reduced costs have been exhausted.

Amazon knew that the market was needing reduced prices... or probably more accurate prices were almost at a ceiling. They used "innovation" to reduce costs initially through process improvements but the ultimate goal is to reduce costs until they cant be reduced anymore. Innovation was only used here because that was the only "disruption" available to the market for many of the reasons listed in your article.

The only reason this approach is not prevalent across smaller businesses is due to competition on both ends of the spectrum, keeping prices low and costs high ( i.e. cant sell for less because too many competitors, cant force suppliers prices down because they have other options... ) so innovation is the best option for profits. But these businesses usually have less funds to be able to throw at innovations.

Australia seems to be a unique case where monopolies and oligopolies are a protected species, usually justified on the basis of "social good" in respect to our market size. Our market size should have had the effect of keeping prices and wages low but its had the opposite effect, our mineral resources have given the market a way out and we all are punished as a result.

anonymous said...

Have you considered that it may be the sheer fragility of the peace among competitors that makes the oligopoly so sustainable?

Mutually assured destruction has a way of focusing the mind. If everyone knows that as soon as they grab for share their super normal profits will evaporate, who would ever try and take share?

Their profits are like the phantom liquidity provided by HFT firms. There until you need it.

Anonymous said...

To a commenter on Jan 27 about "Dr." Dao

Dao behaved worse than a 3 year-old. I love when the Left pretends totally abnormal behavior is normal when it is done by one of their victim groups. The guy behaved like a maniac.

The airlines contract of carriage, an agreement that all customers assent to when booking, does give United the freedom to deny ticketed passengers travel if a flight is overbooked. By law, passengers are entitled to 400% of their ticket’s value (up to a cap of $1,350) as minimum compensation along with a ticket for a future flight.

United paid him off because they know there is no way to win against the Leftist press, who acted as if a grown man behaving like a toddler is appropriate, violating airline rules is fine and also trading on a position of trust for sex(well just hide that part).

harry said...

"The airlines contract of carriage, an agreement that all customers assent to when booking, does give United the freedom to deny ticketed passengers travel if a flight is overbooked. By law, passengers are entitled to 400% of their ticket’s value (up to a cap of $1,350) as minimum compensation along with a ticket for a future flight. "

Your statement is correct but irrelevant. The law specifies that once boarded you cannot force passengers to de-board. The rules also change once you are issued a boarding pass.

This link may be a useful discussion for you.

Once again, Dr Dao might well be the gayest medic on the planet, and a man who indulges in sexual kinks Gilles de Rais would shy away from, but it doesnt really affect his rights of carriage. Not unless he was exercising these sexual preferences on the plane itself.

I hope the link clarifies some of the legal issues. I do not know the extent of the settlement but rumors suggest $140mn. I would hope United did not pay this to that man solely because of their fear of looking bad in leftist press. They still have a responsibility to their shareholders.

Regards and best wishes,

An anonymous, commie, gay PM

Fan Wu said...

The first book enlightened me is Joel Greenblatt's magic formula investing book. And this one is the second. It is an angry book, but it is also a step-by-step guide on how to beat the the market easily over the long run. It is shameful to use a book like this as an investment guide, but this is the only thought I had after finished reading.

Highly recommended and will read it a second time.

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