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The United States has long been portrayed as the land of opportunity and optimism. Unfortunately, at this point in time, most profits seem to be reserved for the elite. According to recent news reports like this one from CNN, nearly 70% of Americans believe the economy is rigged in favor of the rich and vested interests. Optimism has turned to fear, and rational thinking to anger. The words and deeds of Donald Trump don’t just weaken insiders like Hillary Clinton, it weakens our faith, our resolve, and even our patriotism.
Political campaigns in general have found a plethora of people and things to blame, from President Obama to George Bush, or from free-trade deals to the recklessness of Wall Street. With all of this focus on the negative, one problem with American capitalism has been severely overlooked: a corrosive lack of strategic competition.
However, according to The Economist, “The naughty secret of American firms is that life at home is much easier: their returns on equity are 40% higher in the United States than they are abroad. Aggregate domestic profits are at near-record levels relative to GDP.” Despite the unconscionable actions of companies such as epi-pen injector provider Mylan raising their prices an 400%, America is meant to be the temple of free enterprise. It isn’t?
Born in the USA
High profits might be a sign of wise long-term investments, brilliant innovations or even an ability to create strategic barriers to entry, were it not for the fact that they are also suspiciously tie to escalating CEO compensation deals. According to the Economist, “a very profitable American company has an 80% chance of being that way ten years later. In the 1990s the odds were only about 50%.” These statistics are not driven purely by the Apples, Googles, and Microsoft’s of our economy. Some companies are capable of sustained excellence, if they are strategic and innovative, but most would expect to see their profits ‘competed’ away. Today, incumbents find it easier to make profits for longer.
One might think that voters would be happy to see their employers are thriving. But if these employers are not strategically reinvesting, high profits can curtail demand. The excess cash generated domestically by US companies beyond their investment budgets is running at $800 billion a year, or 4% of GDP. The tax system encourages them to park foreign profits abroad, in Ireland of late. Abnormally high profits can worsen inequality if they are the result of persistently high prices,
abnormally rich CEO compensation, or depressed wages. If America’s companies were to reduce prices so that their profits were at historically normal levels, consumers’ bills might be 3%, even 4% lower.4 If steep earnings are not luring in new entrants, we
create conditions that allow firms to abuse monopolistic positions, or using lobbying efforts to quash competition. While I am loath to use the same words as The Donald, the game may indeed be rigged.
One response to this period of hyper-profitability would be simply to wait. Strategic and creative destruction takes time. As we saw in the late 1960s, previous episodes of peak profits ended rather abruptly. The ‘Valley’s’ evangelicals believe that a new era of big data, mobile innovations and robots is about to melt or burn away the fat margins of corporate America. Earnings of listed firms have dipped a little in the past 7 months, in part as cheap crude has slapped energy firms and a very strong dollar has bruised multinationals.
The unfortunate signs are that incumbent firms are becoming even more entrenched, not less so. More than 90% of U.S. industries have experienced an increase in concentration levels over the last two decades. Firms in industries with the largest increase in product market concentration have enjoyed higher profit margins, positive abnormal stock returns, and more profitable M&A deals, suggesting that market power is becoming an important source of value.
Whether from dog food or batteries to airlines, telecoms and credit cards, consolidation is running rampant. More than $10 trillion dollars has changed shareholders in waves of mergers since early 2008. This has raised levels of concentration even further. American companies involved in such deals promise to cut costs by billions claimed from economies of scale, but more often, it is the workforce that gets cut and the quality that suffers. These changes routinely add 10% to the company’s overall profits. Few plan to pass the gains on to consumers, despite what might be said publically.
And there are still more ways to defeat the competition. As the fabric of regulation has become denser, it has also become more brittle. Since the financial crisis of 2007 and 2008, the task of navigating bureaucratic waters has become a more central strategy to a company’s success. Lobbying spending has risen between 30% and 40% in just the last decade, to just over $3 billion. A mastery of patent rules has become essential in both healthcare and technology, the US’s two most profitable industries. New banking regulations do not just try to fence the big banks in; those same regulations also seem to keep rivals out.
With fewer resources and limited access to capital, small companies struggle to survive with all the regulations, forms, lobbying and red tape used to control the larger incumbent players. This is one of the primary reasons why the rate of innovative entrepreneurs and new start-ups in America has been running at its lowest levels since the 1970s. The ability of big companies to enter new markets and take on the laziest of incumbents has been muted by a doctrine among institutional investors who believe that companies should focus on only one activity and keep margins high. Even Warren Buffett, the uber-investor, says he likes to invest in companies with “moats” that protect them from competition. In that vein of thought, if America were a company, it would have managed to dig a giant defensive ditch around itself.
In my opinion, most of the elixirs proposed by the political parties to solve America’s economic adversities would make things even worse. Higher taxes would deter investment. Jumps in minimum wages would discourage hiring. Protectionism would give yet more shelter to dominant firms. The smart play might be to just unleash a harsh, yet nimble wave of competition.
The first casualties might well be the coddled incumbents. Then, the antitrust apparatus could use some serious modernizing, talk about being behind the times. Policing proposed or approved mergers to ensure controls over too much market share and too much pricing power. Companies can extract rents in many ways. From my experience as a strategist, patent laws and copyright protections could be loosened to prevent incumbents milking old discoveries or gouging based on dependencies.
Large technology platforms such as Google and Facebook should be watched closely, not just searched and friended frequently. While neither is yet a high-rent-extracting monopoly play such as Boardwalk or Park Place, but investors value them as if they will one day be one where the money is real. Crossholdings, which are when a publicly-traded corporation owns stock in another publicly-traded company.
So, technically, exchange listed corporations own securities issued by other exchange listed companies. Crossholding can easily lead to double counting, whereby the equity of each company is counted twice when determining its value. When double counting occurs, the security’s value is counted twice, which can result in estimating the wrong value of the two companies individually. Giant fund managers with crossholdings in rival firms should also be carefully scrutinized.
Set them free
Make life easier for startups. Make life easier for small companies. The expansion of red tape and of the regulatory state must be recognized as a problem, not dismissed as the mad rambling of anti-government Tea Partiers or Trumpeters. The added burden laid at the door step of some of these small companies by laws like the Affordable Care Act has been substantial. Banks shackled by rules have led them to cut back on serving less profitable smaller customers and support the actions of the larger players.
The virulent spread of licensing requirements has some good effects, but has also has suffocated startups. Most medical workers require some type of permit, which makes sense. However, an on slot of professions, including hairstylists and the weekend tree house builder, require permits. What percentage of professions or occupations required permits or certifications in the 1940s and the 1960s?
A burst of stiff and strategic competition would result in greater disruption for some. While one in ten Americans work for companies in the S&P 500, encourage competition would create new jobs, better jobs, drive more investment to innovate more and help to lower prices and keep them competitive.
As a strategist, I believe that leaders and companies should focus on the value of growth over time, not on a race to grow the highest possible profits in the shortest amount of time. I have to believe that above all, adopting this perspective would bring about a fairer and more sustainable kind of capitalism – one driven by innovation and good works.
Comments? Write to me.