Consumers hate oligopolies, but this group shouldn’t
Detective Sherlock Holmes, brought to life by the Scottish author Sir Arthur Conan Doyle, is known for his proficiency with observation, deduction and logical reasoning that borders on the extraordinary. “The world is full of obvious things which nobody by any chance ever observes,” he once said.
This brought to mind a question: Are Canadian investors who are enamoured with U.S. equities — and the alluring appeal of the Magnificent Seven — missing some attractive investment opportunities that are much closer to home?
Many Canadian investors are quick to overlook the domestic market in favour of investment ideas south of the border. The considerable media attention given to U.S. equities is a contributing factor, but there are other reasons for this. The ostensible limitations of the Toronto Stock Exchange (TSX) are by now profoundly familiar: there is too much exposure to energy and natural resources; it is underexposed to technology, consumer and health-care names; and the S&P/TSX composite index has noticeably underperformed the U.S. stock market over the past decade.
This consensus has nurtured a predisposition to U.S. equities whereby minimizing exposure to Canada is seen as a preferred method to build a sound investment portfolio. However, there is an underappreciated segment of the Canadian stock market, separate from commodities, that has generated superior returns — with greater stability — than many foreign alternative investments, and it continues to grow steadily. We are referring to oligopolies.
THE POWER OF A FEW
Oligopolies usually offer stability, impressive profitability and relatively notable stock performance when left to operate without notable regulatory intervention.
But what is an oligopoly?
Canadian economist John Kenneth Galbraith said, “an oligopoly is an imperfect monopoly.” A monopoly is a market structure that consists of only one seller, and limits available substitutes for its product by creating barriers for competitors to enter the marketplace. Oligopolies are simply a different way of drawing up a similar game plan to control a particular market.
Given that Canada has a relatively small population spread over a sprawling terrain, our economy seems to be a natural habitat for oligopolies to thrive and flourish. It should come as no surprise that oligopolies dominate various sectors, including banks, communications, airlines, railways and grocers.
For example, the Big Six banks control about 95 per cent of the banking industry. BCE Inc., Telus Corp. and Rogers Communications Inc. account for 88.7 per cent of the telecom market. Air Canada and Westjet Airlines Ltd. command more than 85 per cent of their industry. And you are most likely to do your grocery shopping at Loblaw Cos. Inc., Metro Inc., Empire Co. Ltd., Walmart Canada Corp. or Costco Wholesale Canada Ltd., which command over 60 per cent of the grocery market.
As a result, much of our consumer market offers the theatrics of choice, with many of the participating retailers being sheltered under the umbrella of these large corporations.
THE POSITIVES OF OLIGOPOLIES
As investments, oligopolies can be impressively lucrative. They foster competition in industries where competition is not as fierce. Because industry participants tend to compete on characteristics other than price, there is plenty of pricing power in an oligopolistic market. Conversely, in a hyper-competitive market that competes on price, participants lose all pricing power, and profit margins quickly evaporate.
Oligopolies lead to friendly competition, higher profit margins and fewer choices for consumers, which implies lower customer churn and, therefore, greater profits.
Generally speaking, cosy oligopolies lead to higher profits than industries that are considerably more fragmented. Return on equity (ROE) is a good proxy for profitability. The long-term average ROE is 12 per cent for the S&P/TSX composite and 14 per cent for the S&P 500. Over the past decade, Canadian bank, telecom and grocer profitability has exceeded their U.S. peers, which is directly attributable to higher industry concentration.
Canadian banks returned a 10-year average ROE of 13.3 per cent over the past decade, according to Bloomberg data. This compares favourably to the U.S. banking return of 9.2 per cent. Bear in mind that the U.S. has more than 4,600 banks, and with such fragmentation, there is considerably more competition.
The trend remains convincing when we consider telcos. Canadian telecoms returned 20 per cent over the past decade, trouncing the U.S. industry’s more muted 14.7 per cent. The result was less glaring for grocers, but nevertheless remained consistent, with a 14.6 per cent ROE for Canadian grocers versus 13.8 per cent south of the border.
Regarding returns, Canadian telecoms, banks and airlines have all resoundingly outperformed their U.S. counterparts over the past 30 years. Why do Canadian companies outshine their U.S. counterparts? We can look to the higher industry concentration and tepid competition as the reason.
Subsequently, the track record of investing in oligopolies makes a compelling case for a healthy weighting in these segments of the Canadian market.
RISKS AND CONSIDERATIONS
Despite their various advantages, investing in oligopolies is not without some risks. Regulatory changes, disruptive technologies and evolving consumer preferences can all pose challenges to oligopolistic companies. There is also the prospect of heightened competition from international players or emerging disruptors that could erode market share and profitability over time.
Furthermore, heightened regulation is probably a larger risk. Investors should monitor the regulatory environment surrounding oligopolistic industries, as changes in government policies or antitrust measures could impact the competitive landscape and investment thesis.
However, these regulatory adjustments are usually few and far between, so oligopolies continue to provide a safe and friendly environment for businesses to coexist, and produce superior returns for investors.
The land of oligopolies arguably deserves more credit than conventional wisdom may be willing to attribute to it. Before taking on additional risk to venture outside Canada to invest, it makes sense to pay closer consideration to our homegrown oligopolies for their defensive nature, pricing power and greater stability.