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The ownership question

This year's Nobel prize in economics has been awarded to Oliver Hart. This should be of especial interest to investors, because much of his work has focused upon a question important to stock-pickers: who should own businesses?

Ownership matters for a simple reason. It's because contracts are necessarily incomplete. Even the fanciest lawyers can't write a contract specifying what happens in all eventualities; if they could, we wouldn't need companies at all as we could replace them with market transactions. Ownership gives you control, so your diktat replaces contracts. As Hart wrote, "ownership is a source of power when contracts are incomplete".

But who should exercise this control? The party with important investments, says Professor Hart. This is because such a party will then have an incentive to maximise the company's value. For example, in an oil company, the important investment is rigs and pipelines rather than workers. If a rig blows up, you have a problem whereas if a worker quits he can be easily replaced. But in a law firm, the key assets are people: if the office burns down the law firm can carry on in business but if a big employee quits he'll take a lot of clients with him. For this reason, it makes sense for oil companies to be owned by suppliers of capital while law firms are usually owned by workers.

A big implication of this is that complementary assets should be owned by the same person. Take BP. It owns upstream and downstream businesses. If it didn't, oil extractors could hold it to ransom by threatening to withhold supplies which would render its expensive refineries useless. By owning rigs as well as refineries, BP overcomes this hold-up problem.

But BP does not own Marks and Spencer (M&S), although M&S has franchises in many of its petrol stations. This is because there are fewer complementarities between petrol and posh sandwiches so BP doesn't face a big hold-up problem. If M&S stop supplying sandwiches BP won't lose many customers and even if it did, it could get another company to supply them. In this case, therefore, simple contracts between BP and M&S work well. BP needn't take over M&S.

The corollary of the claim that complementary assets should be owned by the same person is that where there are no complementarities there should be different owners. It's no accident that many conglomerates broke up after Professor Hart's work became known, and many others began to outsource functions such as cleaning and catering.

Thinking about complementarities helps clarify an important question: when do companies enjoy economies of scale, and when do they suffer diseconomies? The answer often lies in the extent to which there are complementarities. Contrast fast-food outlets to haute-cuisine restaurants. Businesses can be big in the former, but rarely are in the latter. This is because of complementarities. An ability to make burgers in Leicester is complementary to that ability in Birmingham because the skill is easily transferred. But the ability to make high-quality food isn't so complementary, because the skill is much harder to learn and a top chef can't be in both cities at once. There are more complementarities between branches of McDonald's than between branches of haute-cuisine restaurants, so fast-food joints have more economies of scale than fancy restaurants. For this reason, even the best chefs have sometimes struggled when they've tried to expand.

This helps clarify another question: when do mergers work? They do so when there are big complementarities but often fail when there aren't. The fact that takeovers often come in waves suggests that they are motivated by factors other than a clear-headed Hartian focus on complementarities. Thirty years ago, Richard Roll suggested that one such motive was hubris: managers overestimate their abilities to overcome diseconomies of scale.

But here's the problem. Shareholders pay insufficient attention to these issues. We know this because they often pay too much for 'growth' stocks and for stocks that have just merged. This suggests they underestimate the importance and relevance of Hart's insight that non-complementary assets provide a barrier to the size of companies.

When you are buying a growth stock or one in a newly-merged company, ask Professor Hart's question: where are the complementarities?

There's something else. Professor Hart's work warns us that outside shareholders are often a bad idea. "Dispersed shareholders have little or no incentive to monitor management," he wrote. And (except when the company first goes public) they are not supplying any important assets, either. So they serve no useful function.

This claim might seem radical, but the facts corroborate it. There are over 2.5m businesses in the UK, but less than one in a thousand of them are listed on the stock market.

This poses the question: if external dispersed shareholding is the wrong structure for most companies, could it be that there are some companies listed on the stock market that shouldn't be?

Professor Hart's work, therefore, poses important questions. Perhaps we'd be better stock-pickers if we paid more attention to them.

MORE FROM CHRIS DILLOW...

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Chris blogs at http://stumblingandmumbling.typepad.com

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By Chris Dillow,
10 October 2016

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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