OB Report
December 2019
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Trust is a Tricky Thing

zicherman By Steven Zicherman MBA, CFA, Equity Analyst

article1-trustOne of my favourite books – The Godfather – begins with the following quote: “Behind every great fortune there is a crime.” The book goes on to tell the story of a fictional New York mafia family, the Corleones. The Godfather is about the Corleones’ unchecked rise to power.

Today, the sentiment toward businesses, especially large technology companies, is evolving. Some fear they have grown too powerful and wonder whether crimes were committed along the way to trillion-dollar market capitalizations.

When I studied business, it was commonly accepted that a corporation’s sole objective was to maximize profit and shareholder return. Today, that viewpoint is changing, as questions about corporate social responsibility are gaining momentum. In August 2019, Business Roundtable, a collection of CEOs of America’s largest companies, redefined the purpose of a corporation to include all stakeholders. They stated that “customer value, investing in employees, fair and ethical supplier relationships, and care for the community and environment are also the purpose and responsibility of a business, in addition to long-term shareholder value.” This evolution is also evident in the regulatory and antitrust political conversations happening now in the United States and Europe.

Today’s largest corporations enjoy significant market power. Google dominates with roughly 90% market share of online searches, while Facebook has almost 80% market share of social media. Amazon accounts for approximately 50% of all incremental growth in online shopping. Finally, Apple captures a significant majority of global smartphone profits. Analysts refer to industries with such domination as “winner-take-all” markets.

Has technological innovation improved our day-to-day quality of life? No doubt! We can use Apple Pay and PayPal to purchase products without cash or even a physical card. Google Maps helps us get around and navigate unfamiliar places. Facebook’s WhatsApp keeps us in touch with friends and family. The bigger question is: Have these daily conveniences come at too high a price?

Last June, the Antitrust Division of the U.S. Department of Justice (DOJ) and the U.S. Federal Trade Commission (FTC) announced that they are reviewing four of the technology companies mentioned above. As reported in The Wall Street Journal, the FTC is looking into Facebook and Amazon, while the DOJ is investigating Alphabet (Google) and Apple. The point of these investigations is to determine whether these firms are unlawfully stifling competition.

Mark Twain said, “History doesn’t repeat itself, but it often rhymes.” In the late 19th century, two of history’s most famous entrepreneurs, Cornelius Vanderbilt and John D. Rockefeller, enjoyed monopolistic status in railway and oil, respectively. In response, the Sherman Antitrust Act was passed into law in 1890 to prevent the concentration of power and prohibit monopolistic business practices, such as price gouging. It took time for reform to work through the system, but anti-monopoly policies eventually became a cornerstone of U.S. politics for decades.

It wasn’t until the 1960s that attitudes toward antitrust changed. The famous Chicago School economist, Milton Friedman, believed that “antitrust laws do far more harm than good and that we would be better off if we didn’t have them at all.” The Chicago School economists were strong advocates for free markets with no government intervention. Regulation has relaxed over the past few decades, and companies have since been left to their own devices. Today, industries tend to be more concentrated with far fewer competitors.

Will the regulatory pendulum swing back to the 1890s? It’s unlikely. Yes, attitudes around business are changing, and there are real concerns over these highly influential companies. One could argue that the winner-take-all model creates less competition, lowers productivity and inhibits new invention. The famed venture capitalist Peter Thiel, one of the original backers of Facebook, is critical of the general lack of innovation today, saying, “We wanted flying cars; instead we got 140 characters” (referring to Twitter).

While many agree there is a need for increased oversight, there is little consensus on how to implement such regulation. Some politicians advocate for breaking big companies apart. Others prefer to focus on improved consumer privacy and well-being. In any event, we believe the probability of drastic political action is modest. Concerns in the run up to elections often turn out to be transitory.

Many expect Senator Elizabeth Warren to win the 2020 Democratic nomination to run for U.S. president. Her message is resonating with people seeking social reform. Warren’s campaign proposes sweeping corporate changes, such as regulating big technology as utilities and reforming big banks and health insurance.

What action could government take to foster more competition? If YouTube was split from the core Alphabet business, would it lose its dominance in online video streaming? Would splitting Instagram from Facebook affect Facebook’s status as the leading social media application? We don’t think so. Whether these companies are forced to split up, or new rules aimed to protect user information are imposed, they would likely remain dominant. Facebook, Alphabet, Apple and Amazon enjoy powerful network effects thanks to their well-established user bases.

Google and Amazon achieved dominance in part due to their experimental work cultures and ability to acquire complementary businesses. The companies’ founders designed their businesses to adapt to change by avoiding corporate complacency. Employees at both are encouraged to experiment with new ideas that could one day unfold into leading products and/or services that strengthen and broaden the respective core businesses. Regulations that impede these efforts, including a moratorium on acquisitions, would have the greatest impact on these businesses.

Outside of the U.S., countries are looking to tax the technology giants. France adopted a 3% digital tax on large technology company revenues. Canada may follow in France’s footsteps. During their reelection campaign, the Liberals said they would levy a similar 3% value-added tax on companies selling digital advertising and user data. The tax would apply to businesses with worldwide revenues of more than $1 billion and Canadian revenues of more than $40 million.

Given the turbulent political climate, modest regulation appears likely. In any event, we remain positive. In a world of economic stagnation and too much debt, we believe investors will continue to flock to large firms with strong balance sheets, durable cash flows and better-than-average economic growth.



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