Superb businesses
A state of perfect happiness for investors?
At first blush investors might think that investing in companies in an oligopoly makes perfect sense. An oligopoly is a business sector that is dominated by a small number of large companies.
For comparison, we know that a monopoly is a business sector with one company and no competition. A duopoly is a sector with two dominant companies.
A growing problem
Many studies have shown that American business is becoming increasingly concentrated. The evidence is cited in an article by David Wessel in the Harvard Business Review in April 2018 titled: Is Lack of Competition Strangling the U.S. Economy? For article see here.
The thrust of the article is to look at the effect of industry consolidation on productivity, wages, and income inequality. I propose to do something different. My focus in this post is to look at the effect on investors.
The phenomenon is worldwide. The Economist magazine has periodically run article referencing corporate concentration worldwide.
The evidence
Wessel writes: “Ten years ago, the top four U.S. airlines collected 41% of the industry’s revenue. Today, they collect 65%. Although competition is stiff on the most heavily traveled air routes, 97% of routes between pairs of cities have so few competitors that standard antitrust metrics would deem them “highly concentrated.” In 1990, 65% of hospitals in metropolitan areas were “highly concentrated.” By 2016, 90% were. It’s a similar story in the beer business. Despite the proliferation of craft breweries, four brewers hold nearly 90% of the U.S. beer market.”
He goes on citing further research: “Of the 893 industries it examined — from dog food and battery makers to airlines and credit cards — two-thirds had grown more concentrated since 2007. Weighted by size of industry, the top four firms’ share of revenue had risen to 32% in 2012 from 26% in 1997.”
As a Canadian I know that many sectors of the Canadian economy are dominated by oligopolies. Banking, airlines and the telecoms immediately come to mind. Canadians consumers are perpetually upset by their treatment by these companies.
A state of perfect happiness for investors?
Wessel again: “…research shows that incumbent firms in a wide range of industries — airlines, beer, pharmaceuticals, hospitals — are wielding market power in ways that prevent rivals from emerging and thriving. The winners are winning bigger, while the number of new start-ups is falling. With waning competitive pressure, productivity growth slows, wages stagnate, and the gap between winners and losers widens.”
This makes it sound like the oligopolies are enjoying increasing defensive moats a la Warren Buffett.
Now the kicker
Until recently it never occurred to me to consider the pros and cons of investing in oligopoly companies. I’ve always invested based on a business analysis of the individual company. I don’t worry about company size, for example. I’ll invest in big companies or small companies. Also, I don’t focus on sectors or themes. I just look for superb stocks priced as bargains where ever I happen to find them. Of course I look at the company business franchise and whether it enjoys competitive advantages.
I was quite surprised to see that none of the companies in our family portfolio are really oligopoly companies. This was not a conscious choice. It just happened. Am I missing something?
The problem with oligopoly companies
The board and management of oligopoly companies can see they have a good thing going. Of course there is no overt collusion with their co-oligopolists. That would draw anti-trust enforcement. Typically there is no covert collusion. That also would be illegal. There is tacit collusion.
The main problem with companies in an oligopoly is that the market share pie has already been divided. It is difficult for any one company to increase its market share. Growth is hard to come by. The companies may generate significant free cash flow but they may not be able to deploy this excess capital at high rates of return, which is one of my requirements for superb companies.
Let me make a few observations:
- Oligopoly companies seldom engage is aggressive pricing behaviour, or price wars.
- Customers often suffer high prices and inferior service. Customers are often grumpy rather than delighted.
- The companies do not have to be efficient to succeed. Thus they tend to be inefficient.
- There is no need to make their products and services cheaper because customers have no choice, so they tend to stay expensive.
- Companies can add fees and charges because their co-oligopolists do the same.
- There is little need to add new ideas to the market place, so they tend not to.
- Some oligopolists have clout to shape the policy and regulatory environment in ways maintain the oligopoly.
- Oligopolies can lead to lack of innovation. R&D money doesn’t go to game changing products. Capital is deployed to defend the status quo. Cash cow business model.
- The companies are often old, household name type businesses. They tend to have career executives rather than entrepreneurs running the show, part of the old boy network.
- Their boards are often populated by the old school network, put in place through the efforts of the CEO and conducive to mutual back scratching.
- Oligopolists often engage in ill-conceived massive lateral takeovers to try to ‘grow’ the business subtracting value.
- Oligopolists often engage in massive vertical takeovers resulting in what Peter Lynch would call ‘diworseification’.
Last word to Wessel
“In a healthy economy, companies continually are born, fail, expand, and contract, while new jobs are created and others are destroyed. A slowdown in business dynamism means that entrenched firms have less to fear from upstarts; as a result, the economy suffers as innovation slows and job growth stalls.”
Conclusion
From time to time I have added companies to our portfolio that, with hindsight, I would now characterize as part of an oligopoly. In future I will happily invest in companies that are part of an oligopoly if they make the cut as superb companies. My only point in this post is that the attractiveness of some companies in oligopolies may only be skin deep. On a closer look they may be yesterday’s companies playing out the string.
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To read more deeply about the kinds of companies we should be investing in, take a look at the Motherlode Part 6: The Hallmarks of Superb Businesses
The Chapters in this Part are:
31. General Approach to Choosing Common Stocks
32. Sectors and Company Attributes to Avoid
33. Thoughts about the Different Sectors and Groupings
34. Bottom Up and Various Qualities
35. Capital Structure, Strength and Economic Performance
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You can reach me by email at rodney@investingmotherlode.com
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
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