My Best Pick 2019

Moat busters

Moat-rich companies can quickly turn into allegory and here’s why it can all go wrong

Walter Bagehot, the legendary editor of The Economist, who commented extensively in the 19th century about government, economics and literature, wrote: ‘To illustrate a principle, you must exaggerate much and you must omit much.’

Even while not following Bagehot’s advice, charges of exaggeration will always be levelled on any forward-looking narrative not couched in probabilities, and sins of omission will be committed owing to limitations of word count. In an era of extreme climate, what can cause the water in a moat to evaporate? What are the functional equivalents of extreme climate for an investor? Here are the top four:

Oligopolistic markets and government regulations: Consolidation of firms is a powerful moat builder and subsequent ‘regulatory capture’ is an equally powerful moat widener. As Jonathan Tepper argues in The Myth of Capitalism, toll bridges have been erected in large parts of the US owing to growing consolidation across industries, leading to stronger pricing power. Numerous examples abound: the railroad industry has, over the past 30 years, shrunk from 30 players to the current Big Four, which are local and regional monopolies; the pesticide industry, where three companies, after the recent mergers, control 70% of the global market; the beer industry, where two companies have 90% market share and prices have gone up, but not owing to ‘premiumisation’ as investor presentations show; airline mergers have led to five large players, and the seat-belt sign has been switched off for industry profitability; the banking sector, where, since the previous financial crisis and with some government-directed mergers and reorganisation, five banks control 44% of the US banking assets. The list goes on.

Industrial concentration seems to be correlated to government regulations which create fresh entry barriers. These barriers are strengthened by close relationships between governmental institutions and corporations.

While the examples pertain largely to the US economy, investors can look at their home markets and are likely to see growing concentration across industries. Industrial concentration is not the objective of governments, but it is, usually, the unintended result. For instance, in India, a significant and bold reform by the government — the Goods & Services Tax — has had the unintended consequence in many sectors of reducing competition from the unorganised sector.

Textbook economics demonstrates longer-term results of oligopolistic and monopolistic industry structures — higher prices, reduced output, lower employment and diminished incentives to innovate. While investors welcome the elevated profitability that accompanies this, history shows that a prolonged absence of significant competitive forces in any free economy is unsustainable.

Technological disruptions: The moats for established players in the tobacco industry could possibly be intangible assets, cost advantages and government regulations. Recent disruptions have come with the arrival of e-cigarettes and tipping points for shifts to next-generation products have probably been reached. Conventional tobacco will not fade away in a hurry, but market-share traction in next-generation products will be critical to maintain valuation multiples for incumbents.

As 5G technology gets adopted, mobile carriers may rely more on small cells such as light poles and less on macro towers which the current tower incumbents operate. The increasing use of mobile data is a huge advantage for incumbent tower companies given the large operating leverage, owing to the capital-intensive nature of the business. Network risk probably prevents carriers from switching. Technological changes, however, remain a key long-term threat to the moats of tower companies.

Similarly, male grooming has faced challenges from low-price competitors and from subscription-based sales models. Spending on technological innovations has been a necessity for the market leader not to narrow its moat.

The consequences of rising inequality: In many economies, wealth and income inequalities have risen, and the social and political consequences of this increase may weaken economic moats, especially those that have been built largely on government regulations.

Some consequences: a) the rise of populism, discontentment and frustration b) the increase in mass movements with Fyodor Dostoyevsky’s ‘right to dishonour’ social and traditional norms and practices c) the rise of Eric Hoffer’s ‘new poor’ — middle classes with stagnant incomes in developed economies and the resultant growth in envy, anger and hatred.

Short of a regime change brought about by revolutions, why should this matter to investors? Because governments could respond by raising taxes or breaking up and restricting the activities of powerful companies and reducing industrial concentration or by a combination of the two. Direct taxes do not impact economic moats but vigorous anti-trust enforcement and the consequent lowering of regulatory entry barriers would.

Take the example of technology-based platform titans which have been investigated by competition commissions in the US and EU for unfair practices. Powerful network effects, scale and ruthless eradication of competitors in their ‘kill zones’ have fortified their economic moats. What could happen to these moats in a harsher regulatory environment where, hypothetically for example, WhatsApp and Instagram are spun off from Facebook’s social network?

Microsoft barely avoided getting broken up at the turn of this century, but it was not allowed to use its monopoly in desktops after the settlement. Google probably exists because of this.

Unsustainable global debt: Excessive debt, financial engineering and risk tolerance precipitated the crisis in 2008-2009. The picture looks worse today with total debt at more than three times the global GDP. The new debt junkies are not consumers, but corporations and governments. They will be tested in the next economic downturn or in a large upward move in interest rates. The next time will, in all probability, be more challenging than the last time. As a recent Emirates NBD report points out that a 1% increase in interest rates on global debt is equivalent to the current size of the French economy.

Economic moats can get impacted by rising interest rates owing to two reasons a) oligopolistic market structures require patience to create and sustain. Studies have found that they break up during periods of high real interest rates, plausibly because higher interest rates require a high immediate discount rate for collusion b) companies, like those in the beer industry, have taken on large debt to fund consolidation through takeovers and may have to go through asset sales and spinoffs to maintain solvency in a hostile financial environment.

No matter what probabilities are assigned, a situation can be viewed with hope or with fear. Hope and fear are two sides of the same coin, for as Seneca wrote: ‘You will cease to fear, if you cease to hope.’