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Investing in cronyism

Crony capitalism can be good for investors – but it comes with big risks
January 24, 2019

Imagine – if you can – that we lived in an economy with textbook perfect competition, in which profits were continually competed down to a bare minimum. This would be terrible for shareholders: any current decent profits would be only fleeting, and there’d be no hope of growth as profits would only just cover the cost of capital.

Or imagine we were in an economy with lots of creative destruction, as described by Austrian political economist Joseph Schumpeter. In this there would at least be some high profits, but these would be at continual risk of being competed away by new companies or new technologies.

These thought experiments tell us something important but underrated – that an economy that is good for customers, citizens or taxpayers is not necessarily good for shareholders, and vice versa. Monopolies are good for their owners, but not necessarily so for customers. And state handouts such as New York City’s to Amazon (US:AMZN) or Tees Valley’s to Ineos are great for company owners but not so nice for taxpayers.

Warren Buffett famously advised shareholders to look for companies with "economic moats" – barriers to entry that protect them from competition. He was right. But he might have added that such moats are bad for customers as they mean higher prices and less innovation.

It’s not just theory that tells us that the interests of shareholders can collide with those of citizens, taxpayers or customers. So too does history. For most of the 1980s, 1990s and early 2000s the US was regarded as a dynamic economy while the French was seen as sclerotic and over-regulated. For most of this time, though, French equities actually outperformed US ones. Between 1976 and 2008, for example, US shares rose 6.6 per cent per year whilst French ones averaged 8.8 per cent. The US economy was better for workers in this period – unemployment averaged 6.1 per cent against France’s 8.2 per cent – but not so good for shareholders.

 

It is only in recent years that US stocks have outperformed French ones. But this has been an era of weak creative destruction and cronyism. In their book, The Captured Economy, Brink Lindsay and Steven Teles describe how regulations such as bank subsidies and tough intellectual property laws have stifled competition and retarded growth. That’s been bad for citizens and consumers and workers (who have seen little real pay growth). But shareholders have done very nicely, thank you.

The point broadens. Across most economies most of the time there has been no positive correlation between economic growth and equity returns, and often a negative one. One reason for this is that the creative destruction that drives economic growth is bad for incumbent listed companies.

All this suggests that as shareholders we should look favourably upon cronyism, regulations and subsidies. It is these that help support share prices. Our interests as investors clash with our interests as citizens or customers.

Or do they? On the other hand, there are dangers for investors in cronyism.

One is that its benefits don’t necessarily go to investors, and certainly not smaller ones. Russia, for example, is a wonderful example of a crony capitalist economy. But it’s not the safest place to be a minority shareholder. Nearer to home, Bank of England research has confirmed what you probably already knew – that the implicit subsidy to banks benefits senior employees and not just shareholders. Similarly, the government’s help-to-buy scheme probably did more to enrich Persimmon (PSN) boss Jeff Fairburn than it did for shareholders.

A second problem is that investors might have wised up to the benefits of cronyism and moats. The fact that these sustain profits might be fully discounted now. Indeed, one reason for the fall in US share prices late last year was that investors realised they had been overoptimistic about the future earnings of monopolies such as Apple (AAPL)

Thirdly, it’s possible that the current lull in creative destruction will be only temporary. Hal Varian, Google’s chief economist, describes how new technologies should encourage more business start-ups – not just in the tech sector – because they drive down fixed costs by enabling companies to outsource cheaply some administrative and accounting functions. And machine learning – which is itself quite cheap – could be used to reverse engineer successful products or services, thereby driving their prices down.

And then, of course, there is political risk. There’s the danger of a backlash against cronyism – contained, for example, in Labour’s plans for higher corporate taxes, nationalisation and worker ownership.

This risk has always existed. One reason why shares did so well for most of the 20th century was as a reward for taking it on; the threat of left-wing governments in the 1930s and 1970s did not materialise and so shares enjoyed big relief rallies. Just because a risk hasn’t materialised in the past does not, however, mean it will never materialise.

For shareholders, investing in cronyism is like riding a tiger: it might be a thrilling journey – until you fall off.