Business AnalysisCharles T MungerLearnings from the Giants

Strong but questionable form of competitive advantage

Charlie Munger in one of his speeches described a test he has performed at a number of US schools –

I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes.

And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. 

And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes. (luxury goods)

And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent?

He further says –

One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent.

You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sale

The Principal – Agent Problem

The concept which Munger wants us to grasp through this small extract is that of agency problem. This is where mental models of ‘conflict of interest’ & ‘incentives’ collide to give rise to this particular behavior. Its not only highly profitable for its exploiters – it is pretty much legal and goes unnoticed most of the times.

In order for this thing to work, three things are required:

(i)  Presence of an ‘agent‘ or someone who acts on behalf of the payer. Essentially acting like a middle men between seller and the buyer.

(ii) Complexity, such that payer or the buyer is unable to understand things on his own. And hence has to invariably rely on such agents

(iii) Absence of stringent regulations. This means that agents are free to deviate and seek to further their own self-interests over that of their clients.

These three combined creates an opportunity for profit seeking capitalists to go for not-so honorable means to generate excess returns by overcharging their customers and sharing part of those proceeds with the agents.

Personally if you ask me, such businesses are painted with those darker shades of grey. It is certainly not commendable kind of work which they do. And those excess commissions which are paid to the agents makes the entire transaction highly inefficient.

Some Examples

Pharmaceutical Companies: Doctor is the last person we would like to argue about anything. Whatever he or she says, to us it is like writing on the wall. And we know that it is upon them where most of the marketing efforts of the pharma companies goes. By paying them commissions based on prescriptions they make, branded pharma companies have successfully earned excess returns for decades. More in so in case of ‘branded generics’ (which is certainly a paradoxical term in the first place)

Financial Services: Here again ignorance of a lay person is exploited by sellers of financial products like brokers, insurance agents and mutual fund distributors. To their unsuspecting clients, they are ‘advisers’. And to the fund houses or institutions whose products they sell, they are called as ‘distributors’. Their principal business is earning commissions. You can imagine where would those money-minded guys like their clients to put their money.

Just like these, there are hundreds of other businesses which have made excess returns over decades by excessively relying on incentives and over charging the end user.

Notes for the investor

(a) Such overcharging can go unnoticed for decades. Many a times clients are indifferent since the magnitude of such overcharging could be meaningless for them in the overall context (think low ticket, but highly important items like medicines).

However, regulators could spring up a surprise anytime. And in a country with as low purchasing power as ours, it is not as difficult for the government / regulators to justify some of its acts.

(b) Also, with improvements in technology, alternative channels are opening up which not only does away with those agents but also removes information disparity between buyers and sellers. For example, its very easy today to figure out generic versions of branded drugs today with just a click of the button. There are websites available which compares financial product offerings across several players in the industry. Till sometime back, it was almost unthinkable!

(c) Another thing to remember is that these excess profits have a disproportionate impact on a company’s bottom-line if a company has mix of regulated products as well unregulated ones forming its sales.

For example, assume a pharma company which has about 10 products forming bulk of its revenues. Now, assume that in 8 out of those 10, it makes a meager 10% margin at operating level. Whereas, for other 2 newly launches products, it makes about 50% margins. The result – it makes around 18% margins.

Now, if for some reason, say due to regulatory push, it is forced to bring down those 50% margins to 10%, the overall profit margins come down from 18% to 10% – almost like halving it! And given that markets uses profitability as a metric to value these companies, market cap would follow a similar journey.

Such examples are far from fantasy. Numbers of many branded pharma companies would convey this story when DPCO came into force couple of years back.

Also, many US exporting generic pharma companies which saw handsome rise in their margins due to back-to-back ‘block buster’ drug launches over last 5 years have also started to see pressures on their margins. Number and magnitude of potential block buster drugs have been declining since some time. (Remember the coveted ‘patent cliff’?)

Having too few products generating super-normal profits can put an investor in a tight spot when margins for those fortunate products starts to normalize.

 

Summing it up

To sum up, investors which are lured into these companies need to be cognizant about the following:

(i) Such businesses work till the time they are ‘under the radar’. Best thing to hope for them is that they never too much attention (especially of the negative type)

(ii) Sometimes, if 2 out of 10 products of a company is sold via such means, you could be sure these 2 products would account for a significant chunk of profits. And the impact of these two going would be huge. This point is more relevant for pharma companies selling ‘branded generics’.

(iii) Assessing sustainability of these is challenging. Hence, never fail to look at alternative scenarios where you put together probability of profit erosion and magnitude of erosion. In the world of technology in which are living, many of those information dis-symmetries between buyers and sellers are slowing going away.

Finally, it may not be the most honorable way to earn money as an owner. In words of Mr Munger, it is akin to spending your life ‘selling something you would never buy’.

It is sort of an inefficiency with capitalism (and our ignorance) has allowed to foster over really long time period of time.

 

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