Jonathan Tepper is the Chief Investment Officer of Prevatt Capital, an asset manager that invests for the long term in high-quality companies. He also co-founded Variant Perception, a company that provides investment research to asset managers, and Demotix, a citizen-journalism website and photo agency sold to the then-Bill Gates owned Corbis in 2012.
His books include Endgame: The End of the Debt Supercycle, and Code Red, a book on unconventional monetary policy. His latest is The Myth of Capitalism: Monopolies and the Death of Competition, named one of the best books of 2018 by The Financial Times.
In November 2020, Anne Shelton, CIO of ATAPCO (American Trading and Production Corporation) interviewed Jonathan live on the iConnections Investment Institute platform, to help our members understand more about his book, the problems with modern monopolies, and how investors and allocators can use this knowledge in future.
How did the writing of The Myth of Capitalism come about, and what is its central thesis?
The book came about almost by accident. I didn’t set out to write a book, I was trying to solve a problem. I was trying to figure out why corporate profits where so high in the United States, and the inverse of that: why wages where so low and why this was persisting. It didn’t appear to be strictly cyclical, where corporate profits go up in the good times and down in the bad times, it seemed to be much more structural in nature.
I undertook a lot of research and the thesis of the book is the outcome of that research. After time we have seen merger after merger leading to fewer players — about two-thirds of industries in the United States have become highly concentrated over the last 15 to 20 years. This has knock-on effects in terms of less bargaining power for labour, higher profit margins for corporations and less economic dynamism.
You end up with fewer competitors coming in to compete with the big players, because they control the markets. You end up with less economic vitality. Since 1997 we’ve seen the number of public companies halve in the United States. There’s been a couple of years in the last six years when more businesses disappear than new business are created, so that’s obviously very bad for economic dynamism. The harms to the economy are many.
So what are the harms that an average person would see in their daily lives?
It varies but broadly the one Americans see is the medical sector and insurance sector are highly oligopolized. Over 75% of all states are highly concentrated. We have one or two players who completely dominate the healthcare insurance market, many if not half of all cities in states are highly concentrated when it comes to hospitals. Everyone ends up paying a lot more for that.
The US has 18% of GDP devoted to healthcare versus the other OECD countries, who are closer to 10-11%.
You end up getting lower wages. The US agricultural centre, for example, 3-4 companies control almost everything, whether that’s beef, chicken , wheat, soy, you name it. And this happens in many industries, so it means that the bargaining field in terms of wage earners versus employers is always shifted in favor of the employers, if you only have one or two people who might bid for your services. And in fact the DoJ has brought cases against collusion where companies agree not to poach each other’s workers or agree not to compete against each other too vigorously on wages.
You’ve written a book that talks about the myth of capitalism. When you say it’s a myth what do you mean by that?
The title comes from a statement made by a Polish economist called Kalecki. He was saying that
capitalism involves private property and competition. If there is no competition then this idea of capitalism is almost mythical, it doesn’t exist. It’s for that reason that you end up with local monopolies and national oligopolies that drive up prices and have very limited competition. And that is certainly not what people have in mind when they think of a vibrant free market with very many players offering their services to consumers.
You distinguish between natural monopolies and unnatural monopolies, can you talk to us about both?
Certainly. In economics classes the term natural monopoly is generally applied to, for example, utilities, whether that be copper wires that are laid down to deliver electricity to people’s homes, or water pipes, it doesn’t make sense to have two water companies delivering water to a particular town. These kinds of monopolies have very high up front costs, and because they are public goods so they are regulated so their rate of return is capped.
I use the term natural monopoly a little more broadly: these are industries where the delivery of the product dictates that there be few suppliers. You might find this in, for example, stock exchanges or futures exchanges where everybody wants to be in the same place at the same time to trade. So there’s a reason why the London Stock Exchange was the place to trade shares for centuries without anyone passing laws or making rules saying you couldn’t trade somewhere else. People just wanted to be in the same place.
Unnatural monopolies are industries where you have one or very few players and this is driven by law. You or I could decide that we want to in and compete with a health insurer in a given state, but we can’t, because the laws are very onerous and don’t permit that.
So in the US, for example, you can freely ship a Coke from Georgia, which is where Coca-Cola started, to South Carolina, but you can’t sell insurance across state lines. And you find this with pharmaceuticals, you find this with airplane parts, so anything that has to be approved by the FDA or FAA. These processes often take an enormous amount of time and there’s very little incentive for any kind of reform or improvement in this process because it serves a limited number of companies very, very well. So often the more highly regulated the sector, the more unnatural the monopoly, where people would gladly come in and compete if they could.
We’ve seen lots of books on antitrust in the past year, and there is a lot of conversations about this, particularly with tech companies. Do you think there is a sea change underway?
What’s leading to all this interest right now, and what do you see coming out of it?
There has been, over the last 24 months, and it’s really accelerated in the last 12 months, a lot of book on monopolies; we have Tim Wu’s The Curse of Bigness, Matt Stoller’s Goliath, Zephyr Teachout’s Break ‘Em Up, just a series of books; you know it’s extraordinary to think that there are so many books coming out at the same time about this. The reasons are twofold, I think: One, there’s obviously big Tech, which people are focusing on a lot, and many of these books focus particularly on that, but if you think of the World Cup, where you start with sixteen teams, then you go down to eight, then four, and so on, then what we have seen since the early 1980s is a merger wave pretty much every decade, often in even less than a decade. The first merger wave is not a big deal, the second creates fewer competitors, we’re sitting here now in 2020 and we have, in many industries, 3 to 4 players maximum. We’re essentially at this culminating point with far fewer players in many industries, and I think that’s one of the big reasons.
I think when we do see a sea change in Antitrust, it generally doesn’t happen quickly. So going back to the Sherman Act, which is now 130 years old, there has been these very big swings of the pendulum back and forth, sometimes driven by presidential appointments and sometimes driven by new laws, or new interpretations of laws. If you look there are almost no horizontal mergers in the 1960s and 70s, they were all actually vertical and that’s when you’ve got conglomerates. But then going into the 80s Reagan made the appointment of Baxter to the Department of Justice; that started the pendulum swinging. That’s taken about forty years, and we’re now at the end of a very long swing, a long move towards greater concentration. I think that we’re now starting to see the pendulum swing back and I think it will take quite some time — so I wouldn’t get worked up about everything changing overnight, even if that would be a good thing. These historical processes take quite some time.
It sounds as though part of it is that for these companies, there is not much further that they can go — they’re already at their limit, there is already so much concentration. But does that indicate that there will be a swing in reverse?
I think that there is certainly a change in social mood. Obviously that’s one of the things driving these books. A curious thing is that you could say, well, Republicans are more in favor of big business and Democrats are more in favor of the working man and small business; but what you find when you look at it over time is that it doesn’t really make any difference. There’s a very big revolving door between the K Street law firms, Compass Lexicon and Charles River Associates, and so people who have served on the FDC under either Democratic or Republican presidents, take some time out, go to work for a law firm, come back in. So they are then making decisions or passing judgement on their former clients. As you can imagine, this is a very cosy relationship.
Reform or change is not inevitable and I think people would be sorely disappointed. Trump on the campaign trail railed against big tech, then the people he appointed to the FDC were former lobbyists for Google.
One could say republicans could be in favor of big business and vice versa; in time, it doesn’t make any difference. Both happens under both parties. They are all making decisions based on their former clients. Trump went against big tech on the stump but his advisers end ed up being from big tech like Google.
The phrase of ‘Draining the Swamp’ comes to mind. I thought that was what that was all about, but I didn’t see a whole lot of it. So what do you think will happen under the Biden administration?
This is a big unknown, what he specifically might do. He seems a little more populist than Obama, based on many of his statements about business monopoly. Certainly Obama seemed to favor greater concentrations. If you look at Obamacare for instance, one of the reasons it got through, unlike Hilary Clinton’s effort with Bill Clinton as president to reform healthcare back in 93, is that Obama brought them on board. They realized they were going to be able to merge and end up with bigger hospitals, bigger insurers, and that was something they were in favor of, they could get better pricing power.
Biden seems a little more against concentration; but people he is appointing to various transition posts, and naming, these people are part of that revolving door crowd. So I suspect, again, unless there are moves in the House and the Senate, and there are plenty of people there who want reform, such as Representative Dave Cicilline who held the tech hearings in the house, and who I think is brilliant, a very smart guy. We might see more legislative moves than presidential moves in terms of monopolies.
What kind of legislative moves do you think will happen, and does that depend on what happens with the Georgia Senator races?
The laws are all on the books that we need to make any positive outcomes when acting on monopolies. The big problem for the last forty years has been under enforcement, or viewing low prices as being the be-all and end-all. And therefore any merger that promised low prices can go through. These acts already exist. Technically there’s no real need for any more acts. The problem is that it’s now become so deeply ingrained in the judicial process and in the thinking that only harms are price harms, not wage, competition, or anything else, that it’s likely that a new act is needed to redefine what the Sherman Act should be; I think that a law is probable.
Also we have the technology platforms which were not around when these laws were written and I suspect that is one of the things that might come out of this. People have their own reasons for reform, and people on the right are now thinking, do we really want one or two people to be able to censor and put a flag warning on whatever you want to say? Obviously there are different views, but everyone is motivated by their own reasons for reform. So I think if the Democrats get the house and Senate as well, I think it’s more likely, if Senator Warren who spoke about this a lot on the campaign trail, she is very bright and understands the issues very well. You could have Cicilline in the House and Warren in the Senate and a lot of people who have very strong views on these things with the ability to write laws.
Do you think that Biden will bring more Antitrust cases and use that lever?
There are many years under Obama presidency where not a single case was brought. So counting on a President due to their political leanings either left or right can often lead to misjudging the outcomes. Biden talks more about big business but I don’t know if he’s just going to be another Obama on this. I talked to some people on the Democratic side who are on these Antitrust, antimonopoly movement, and they don’t know very well either. It’s a big question, the tide is certainly changing, there are many think tanks and grass roots movements on both sides of the spectrum. It’s now much becoming much more bipartisan that having that concentration of power is not a good thing.
Can we talk about specific sectors and drill into them a bit more deeply?
In my book The Myth of Capitalism, in one of the chapters, I was just touching the tip of the iceberg, but I listed I think about 30 sectors, which gives you a sense of how deeply monopolized we have become.
So if you look for example at telecommunications and cable — while there are many big cable providers in the US they don’t compete with each other at all they are local monopolies, so because of this, Americans pay much higher rates than Europeans do.
Healthcare and its counterpart, health insurance is also a highly concentrated sector. In 37 states you can’t open a hospital unless you get a Certificate of Need stating that there is a need for a hospital — imagine Starbucks needing a statement that an area needs coffee before they could open a store somewhere.
Agriculture is possibly the most concentrated sector; it’s like an hourglass, where you have at the top the ones who are producing meat, grains, the farmers. Then at the bottom you have 330 million people consuming the food; and in the middle of that hourglass you have three or four companies whether that’s Cargill, Archer Daniels Midland, Tyson, all these companies who capture the bottleneck.
There are other ones that are unnatural monopolies. Ratings agencies, for example. Moody’s and S&P. You or I couldn’t start a company like that if we wanted to, because there’s an act of Congress which creates the NRSRO ratings designation. And it’s almost impossible to get that.
You can’t have your bonds be held by pension funds or insurance companies unless they are rated. The list goes on and on.
Supermarket shelves are rife with oligopolies and monopolies. The cereals monopoly for instance, goes back decades. The same three companies that started up in the 1860s are still competing against each other. A lot of that is due to slotting fees, companies pay to be slotted, and if you are a small company good luck getting on the shelf.
The tech giants are the ones that people focus on, and they certainly are very monopolistic, with up to 90% of their markets, but they are only the tip of the iceberg. The ones that the average consumer doesn’t encounter every day actually costs them more, say in terms of healthcare and insurance.
Are there any sectors that have been given temporary changes during covid, and will it continue?
There might be some things moving in the right direction during Covid. But often it’s in the other direction; what we’ve actually seen is that only the big companies are allowed to keep their stores open; Amazon is allowed to deliver, for instance, and independents are closing. Believe it or not, half of black businesses have gone bust in the US this year. Big players have plenty of access to bank lines; if you’re a small player you don’t. 2020 in a way works against my idea that we are seeing a sea change; maybe politically we were, as the Overton window moves in terms of what we see as acceptable. But what we see in practice is a decimation of small businesses as big businesses are the only ones still opening and working, delivering and having access to credit.
Let’s talk about how these thoughts apply to investing. My first question is this; if concentration has negative effects on society but is good for shareholders, what should a responsible shareholder do?
The book The Myth of Capitalism starts out talking about Warren Buffett and Peter Thiel. Peter Thiel has criticized competition and praised monopolies — a large part of his book Zero to One is in praise of monopolies. Buffett himself has said he wants to buy businesses that are monopolies that your idiot nephew could run. Businesses that are do dominant that even someone dumb couldn’t mess them up. There is a reason why the both like them, and that is because most of these companies produce very high shareholder returns. You don’t have a competitor drawing down on your return on capital, or eating away part of your pie. So there’s a tension between what is good for society and what might be good for monopolies.
Again, going back to natural versus unnatural. The unnatural ones quite clearly are bad; absent some rule and we would have more competition. On the natural side, meaning that the delivery of the product dictates that you have fewer players, I think that’s one area where investors can and should hunt.
For example if you think of the US railways, what you have are local monopolies, where they may have been more players in the nineteenth century but today its very hard to see new railroads cropping up, due to rights of way, the difficulty of assembling a network. So you have a very strong network of facts and you have these local monopolies. Again, the railroads are pretty good businesses that have been around for a fairly long time with high returns on capital. No surprise that Warren Buffett bough Burlington Northern
I think if you look at stock exchanges and futures exchanges, those are natural monopolies that have existed in most countries — Amsterdam was one of the first stock exchanges — these are pretty good investments.
One of the interesting things that I didn’t write about in the book — the book was more about history and public policy — but one of the things that I spent a lot of time on afterwards, writing reports for Variant Perception, before I started by investment firm Prevatt Capital, is the distribution of stock returns. When you look at which stocks create most value in the increase in price of an index, it tends to be a very limited number of stocks. It’s actually a very small number that drive returns. If you look at all stock markets globally, they follow a Pareto distribution, an 80/20, more or less. As an investor you don’t really want to be buying any random company and chasing returns in competitive industries; someone is going to eat your lunch. What you really want to do is find natural monopolies where the delivery of the product dictates fewer players, and where these companies can have a competitive advantage period that’s quite long. And if you can do that then it’s much less likely that you’re going to see your stock returns underperform T-bills, which is likely to happen. There are some industries, for example oil, where the only constraint is access to capital, and we have seen hundreds of billions of dollars worth fo defaults in the shale oil sector. That’s because anyone with capital can drill, so you end up with oversupply. Retail tends to be very similar. Anyone with capital can go rent a store, create a new concept, or imitate someone else’s concept. There are certain industries that are much tougher in terms of generating returns. I think that investors need to realize that returns globally are Pareto-levied, you do want to own the winners. You can take two approaches to this: one is Warren Buffett’s approach, which is to say you can reasonably identify these and own them in a decent concentration. Or you could take the Bogle approach, which is to say we don’t really know what the winners might be in advance but if you buy the index, then the winners will be driving up the index. You own the index, and try to do that with the least fees possible.
Both of these work and both have their drawbacks. The Buffett approach requires a lot of time and attention and care, which a lot of investors just don’t have, at least on the retail side. The drawback to the Bogle approach is that you can often end up with companies you don’t want to own because they are a part of the index. So a more concentrated approach could be better; at the same time, sometimes, particularly lately, because some of the returns are driven by the index itself, you are ending up with irrational reasons for some of these stocks going up. They tend to be very concentrated and overvalued at peaks. And whichever the top ten stocks are in the S&P in any given decade, they tend to underperform the index in the following decade, and that’s one of the problems of the Bogle approach.
Is your policy standpoint in conflict with your shareholder standpoint? Do you think the policies aren’t going to be changed, and that we should bet our money on investing in it continuing?
On the one hand what I think we need is more deregulation, particularly in the areas that impede competition. For example, Buffett bought VeriSign. VeriSign has astronomical operating margins because they have the monopoly on assigning domain names. And this is one that I hope gets changed, I think it would be much better for everyone. Moody’s— and S&P likewise, Buffett has owned S&P in the past and seems to like these unnatural monopolies. I hope those get changed, and I would like to donate my own money — and I am doing it, to make that happen.
There are other types of companies that have natural monopolies, meaning that if government had no involvements, you would still end up with very few players. These are companies that have very strong network effects, or provide a great benefit to users, and often these are created by the industry themselves. For example Everisk, when insurance companies needed pooled information on risk. VISA, essentially was a consortium of banks; exchanges were just places where traders got together. So you have a variety of these kinds of companies where if they didn’t exist you’d have to create them, as there is a real need for the consumer.
MEMBER Q&A SESSION
Do you believe the large, dominant, monopolistic firms of today, many of which are internet giants, will persist?
If you look at technology companies historically very few have persisted for a very long period of time. Part of the reason for that is that technology changes quickly. If we had had this conversation forty years ago, we would be talking about IBM; and you can remember Steve Jobs in the 1984 commercial. Interestingly Microsoft started dominating in the 80s and it is still around.
I think the companies that tend to do well are the ones that create an ecosystem that others depend on and are essential. For example, Microsoft is critical when it comes to desktops. The vast majority of people around the world are running apps on a Microsoft desktop. And so they have made that absolutely essential.
Facebook for example is very interesting. When you talk about barriers to entry, generally, overlapping barriers are strongest. A barrier on its own might not do very much. Switching costs are critical, from the investing side, because if you can’t switch then you have captive customers. In the case of social networks, the fact that your friends are all on a social network doesn’t mean all that much if you and all your friends can switch pretty quickly. A classic example is that Facebook was not the first: you had Friendster, then MySpace, and Facebook was actually the third. So being first isn’t actually what keeps you up there. Facebook has just been trying to make itself stickier — whether they will remain sticky in the long run, I don’t know. They had to buy Instagram and WhatsApp and that’s where a lot of their dominance comes from, by controlling lives that are then hard to switch away. Those are some of the considerations on the tech side. Oddly it would lead me to like Microsoft more than the others, and obviously that stock has done quite well, but people didn’t think that before Nadella become CEO.
What are the broader investment implications of your studies, are all monopolies created equal, and which specific sectors or companies do you favor?
The investment implications, first there was The Myth of Capitalism, then I did a lot of research and Variant has some very detailed reports on the distribution of stock returns, is that you really do from an investment standpoint want to avoid industries with no barriers to entry, where competition does work. The problem is that you can have unnatural barriers which impede that competition, or natural ones; and that’s what insulates them. But as an investor you want to stay away from the shales of the world, or highly competitive retail; and the long term returns are driven by a limited number of stocks. If you can keep that in mind and think: is this company going to face a significant amount of competition, and does it have any barrier to entry, that will be a bigger determiner in the long run over whether a stock will do well, versus whatever short-term considerations you might have on valuation.
In terms of whether some are better or not, this comes back to how you might think about the company in general, whether it’s a monopoly or not. Companies that promise high returns on capital, and generate more free cash flow, tend to be better. Cement an aggregate are local monopolies, and the reason for that is that it is very expensive to transport cement 100 miles; it’s uneconomical. You have a radius around a cement or an aggregate plant where they can deliver. It’s capital intensive, it’s highly cyclical in demand, and so if you look at the stocks of cement companies they haven’t really gone very far, they tend to move up and down a lot. They don’t tend to get a lot of new competition but they don’t make phenomenal investments.
If you can find a company that can return capital to the shareholder, or ideally reinvest in its own business growth, that’s where you get great investment returns. One of the factors driving a purely quantitative approach to stock picking but also does well in terms of telling you which ones are better or worse in dominant companies, is looking at gross profitability to tangible assets or return on assets. If you’re constantly having to reinvest in your assets it’s much less likely that you are going to see much of that as a return, even if you own a dominant cement company.
Given the state of industrial conditions, how should investors best position themselves to take advantage of the situation?
Right now is a very interesting time, from a couple of standpoints. One is that there are some parallels to 1969, where we had the go-go years, where rates were very low in the 1960s, gross stocks and stocks that had merged had gone up a lot and that produced very poor returns moving forward for a lot of these gross stocks. Right now I think there are some companies that are very good, that I track, and are in dominant positions, but because rates are very low, valuations are quite high. So it’s not like I’m the only person who’s ever told this audience that you might want to own a high quality company with limited competition! You still have to be wary of what the valuation is. So right now you have many companies that I think are highly valued, and I think that may be a challenge over the next ten years. I think it’s worth paying attention to that. For example I was talking earlier about exchanges: there’s a phenomenal called Market Access that trades corporate bonds — the valuation is very high; yes, you might make a return over the next five or ten years with the company but it’s certainly much more challenging than having bought two years ago when the valuation was much more reasonable. The other one is, I would stay away from very unconcentrated industries; when I was at Variant, one of the reports was about shale. The lack of barriers to entry was one of the key problems, but also all of the shale companies scored very highly for bankruptcy on the Altman Z-score. And I think that one of the most useful things that investors can do is to consider if the industry is very unconcentrated or not but also having that outside approach. Kahneman talks about inside versus outside approach. If a company scores very highly for bankruptcy, they are probably going to go bankrupt. That’s fairly simple. Some of these heuristics right now are useful in terms of allocating portfolios.
Can you quantify the economic impact on a particular sector of getting rid of monopolies and having a truly competitive market?
I think on the consumer surplus and GDP side, I think GDP is much harder to do, surplus is a little bit easier just because you can argue that surplus is the inverse of the pricing. There has been quite a lot of work done looking at price increases in industries that went below six players; an economist from my book said that you can look at all the FDC challenges to mergers, and you can look at all the merger databases; when an industry goes below six players then that is generally the point at which pricing went up. So to the extent that we have these databases and we can see where pricing went, you can make calculations as to how damaging these are to the consumers. So that is one of the things that would be, I would argue, the best way to approach the problem. I think the damage to GDP and economic dynamism is certainly one that would require a lot more assumptions. When I build financial models one of the first things I look for is ‘garbage in, garbage out’. And I think we’re learning that with epidemiological models this year. I would hate to say what the harm to GDP might be based on increased mergers.
This content was transcribed by the iConnections team.