Golden eggs are no reason to kill a goose

THE most valuable companies are those with long-lasting, more or less permanent advantages over the competition — advantages that will not “fade away” over time. These are companies protected by the proverbial “moats”, filled with crocodiles that can keep out potential invaders.

Protection can be provided by brands that translate into good profit margins. Or by intellectual property that is difficult for competitors to replicate, to reduce their pricing power. Companies that generate a flow of ideas from large budgets for research and its growing application can also help keep competitors at bay.

Such advantages for shareholders will be revealed in persistently good returns on the capital they provide. They will be firms run by managers who are well selected and properly incentivised, and governed by a strong board, including executive directors with well aligned financial interests in the firm. And the best growth companies will have lots of “runway” — a long pipeline of new projects in which to successfully invest additional capital and increase scale.

Good returns on capital mean internal returns on capital invested by the firm that consistently exceed the returns of similarly risky shares available from other listed companies.

Companies that are expected to perform well for long naturally command high share market values. Rising share prices convert high internal rates of return on capital invested by the firm into lower, more normal returns for shareholders. Thus, the best firms may not provide exceptional share market returns — unless their excellent capabilities are consistently underappreciated, an unlikely state of affairs given the strong incentives active investors and their advisers have to find hidden jewels in the marketplace. They are the great firms that have to continuously pass the market test run by customers and consumers.

Such excellent companies may well enjoy a degree of market dominance. Their pricing power, profit margins and high returns on capital will be testament to this. In other words, they are so effectively competitive that they prove to be consistently dominant in their marketplaces and so enjoy a degree of power to set their own prices and terms of sale or supply. But such power in the market is bound to attract the attention of the competition authorities. The highly successful company may then have to prove that it is not abusing such market dominance.

The fact that their returns on capital are consistently high may well be taken as prima facie evidence of abuse. Clearly they could have survived as businesses earning less than they have been doing. They may well be instructed to change business practices that have served them and their customers or suppliers well, but may not satisfy some theoretical notion of better practice and the changes will inevitably raise their costs and reduce their profitability.

Market forces and market dominance are best left alone to work themselves out. That is because innovation is a constant, disruptive threat to even the best managed and dominant firms. They will sensibly attempt to profitably grow their business by serving their customers well enough to hope to keep out the potential competition, attract additional custom and constantly innovate. Their managers have every incentive to retain and increase their base of custom to serve the longterm interest of their shareholders.

The competition authorities (nor any other outsider) will not know better how a dominant firm could or should act in the full public interest. The broad public interest in an efficient and strongly growing economy depends on the free play of unpredictable, dynamic market forces and on successful innovation that is the true essence of competition, which is well revealed by market dominance.

Kantor is the chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity.

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