The paradox of competition. You can lose because you have won the game.
When portfolio managers and active investors value a company, they are bound to seek out companies’ advantages that can keep actual and potential competitors at bay. Moreover, they seek companies with long lasting, hopefully more or less permanent, advantages over the ever likely completion, advantages that will not “fade away”, in the face of inevitable competitors.
The talk may be of companies protected by moats, preferably moats that surround an impregnable castle filled with crocodiles that keep out the potential invaders, that is the competition. Reference may be made to protection provided by loyalty to brands that translate into good operating profit margins; or to intellectual property that is difficult for the competitors to replicate and reduce pricing power. It’s a search for companies that generate a flow of ideas that lead to constant innovation of production methods and of products and services valued by customers; and those with good ideas that will receive strong encouragement from large budgets devoted to research and development that can help sustain market leading capabilities through consistent innovation that keeps competitors at bay.
Such advantages for shareholders will be revealed in persistently good returns on the capital provided by shareholders and invested by the team of managers – managers who are well selected and properly incentivised, and also well-governed by a strong board of directors, including executive directors with well aligned financial interests in the firm. Furthermore, the best growth companies will have lots of “runway” – that is a long pipeline of projects in which to successfully invest additional capital that will be generated largely through cash retained by the profitable company. By good returns on capital is meant returns on capital invested by the firm (internal rates of return: cash out compared to cash in) that can be confidently predicted to consistently exceed the returns required of similarly risky shares available on the share market, that is market beating returns.
Such companies that are expected to perform outstandingly well for long, naturally command very high values. Their high rates of profitability – high expected (internal) rates of return on the shareholder capital invested – will command great appreciation in the share market. High share prices will convert high internal rates of return on capital invested into something like expected normal or market-related returns. The virtues will be well reflected in the higher price paid for a share of the company. Thus the best firms may not provide exceptional share market returns, unless their excellent capabilities are consistently under appreciated. This is an unlikely state of affairs given the strong incentives active investors and their advisers have to search for and find hidden jewels in the market place.
Such excellent companies – market beating companies for the long run – are therefore highly likely to enjoy a degree of market dominance. Their pricing power and profit margins will be testament to this. In other words, they are companies so competitive that they prove consistently dominant in their market places.
But such market dominance – that has to be continuously maintained in the market place serving their customers better than the competition – has its own downside. It is bound to attract the attention of the competition authorities. The highly successful company – successful because it has a high degree of market dominance – may have to prove that it has not abused such market dominance. The fact that the returns on capital are so consistently high may well be taken as prima facie evidence of abuse that will be hard to refute. It may well be instructed to change business practices that have served the company well because they do not satisfy some theoretical notion of better practice. Such companies have become an obvious target for government action.
Foreign-owned companies that achieve market dominance outside their home markets may be particularly vulnerable to regulation. These interventions are designed perhaps to protect more politically influential but in reality less competitive domestic firms. Hence the actions taken by the European competition authorities against the likes of Google, Facebook and Microsoft who have proved such great servants of European consumers.
And so one of the risk of competitive success is that such success will be penalised by government action. A proper appreciation that market dominance is the happy result of true competition that has proved to be disruptive of established markets, through the innovation of products and methods, would avoid such policy interventions that destroy rather than promote competition.
Market forces and market dominance can be much better left to look after themselves, because innovation is a constant disruptive threat for even the best-managed and dominant firms. These firms will know that dominance may well prove to be temporary and so they will behave accordingly, by serving their customers who always have choices and by so doing satisfying their shareholders. 14 September 2016