The perspectives of UK investors and the wider economy
Warren Buffett, the legendary US investor believes that every company he finances should have a moat. This is not the behaviour of a rich eccentric obsessed with medieval water features. It is a shrewd financier keen that his investments are protected from competition.
Buffett’s metaphor asserts that a company’s competitors are akin to the castle raiders of yore – eager to scale the walls and steal the treasure. In the case of a company that would be their market share, their earnings and ultimately their profits. Buffett’s success over many decades – and his wonderfully simple logic – means almost all fund managers use this approach when choosing how to invest client money.
So when it comes to encouraging investors to part with their cash having a deep and broad moat helps. This helps explain why patents, licences and intellectual property are so fiercely guarded.
In economics however the argument over moats is more nuanced. In particular, too many barriers to competition and incumbent companies become complacent. They fail to innovate. Too few barriers and the rewards necessary to encourage investment can too easily be plundered.
So does today’s UK economy have the right balance?
The question is of huge importance to understanding productivity and investment. The UK is a laggard in both of these areas.
Since 2000 the UK has allocated just 16% of its output to investment, compared to the G7 average of 21%. In Research and Development the UK invests just 1.7% of GDP against an international average of 2.4%. And on productivity the UK has stalled since the global financial crisis, growing at just 0.6% a year. This compares to an annual rate of 1.9% in the decade preceding the crisis. Together these are dire numbers. Any serious investigation into their cause must look beyond government funding and financial incentives and challenge the ways in which UK markets are regulated. The needs of investors need to be balanced with the wider interests of the public for whom productivity and increased pay are firmly intertwined.
Recent Bank of England research has identified a small number of exceptionally productive “frontier” companies and a large number of “non-frontier” companies with much lower levels of productivity. The inference from this research is that if this long tail of less productive companies could close the gap then UK productivity could be radically enhanced. Indeed the Bank of England’s Chief Economist, Andy Haldane, has estimated that a convergence in productivity growth between these companies could deliver a boost to aggregate UK productivity of around 13 per cent. This would take the UK to within touching distance of German and French levels.
So far, so good.
However there are two ways of reading this divergence in company productivity. The first is that non-frontier companies are protected behind their own economic moats and are able to fend off the creative destruction of more productive insurgents. Proponents of this view would advocate wide-ranging market deregulation to open up competition as well as investment in management and vocational skills.
But there is an alternative interpretation which is that frontier companies have established deep moats that make it exceptionally difficult to duplicate their methods, diffuse their technical expertise and replicate their scale. Taking on these monopolies as they develop, shallowing their moats through competition law would represent a very different policy response to the same problem.
In the Government’s recent Industrial Strategy it appears that Ministers avoided taking a view one way or the other. The Strategy noted that “We are not as good as other countries at spreading the best practice of our top performers”. I suspect the linguistic ambiguity was deliberate. However there is evidence to support the view that the market dominance of a few companies is more relevant than the inertia of the long tail.
Firstly, many of the frontier companies are based around digital platforms whose structure enables them to reach huge markets. This change in market structure has rapidly shrunk the number of companies it takes to supply the UK economy. In an increasing number of sectors it is difficult to identify the number two; such is the profile of the dominant platform. While the reasons for the dominance of companies like Amazon may be disputed, it is difficult to envisage other retailers being able to adopt similar methods to get their products to market. This brand recognition is a wide moat indeed. It makes the ability of insurgents to replicate its methods exceptionally hard. The dividing line between necessary innovation and repressive dominance is a live policy question.
Secondly, there is no evidence of a lack of dynamism amongst UK companies. An economy in the middle of its third longest expansion since the Second World War and a streamlining in the process of company registration has made it an exceptional time to be a start-up. The result has been a recent surge in the number of UK businesses – 2.8 million in total – with a post-crisis high of 414,000 created in the last 12 months alone.
Thirdly, it would be highly unlikely that innovative, commercially-viable ideas should be concentrated amongst a small number of companies. It would be even more unlikely with the low cost of diffusing information that awareness of new management and production techniques is a material barrier.
Fourthly, UK investment funds continue to have a bias towards large, high-profile companies. This was recently recognised in the UK Government’s Patient Capital Review, but was acknowledged as a barrier to growth as far back as 1931 by the MacMillan Committee. Finance has failed to trickle down to small and mid-sized companies looking to grow, in spite of rock bottom interest rates and £435bn of money creation by the Bank of England.
So the long tail of low productivity companies is not necessarily reflective of the lack of innovation or ambition amongst this group. It is more likely the reluctance of regulators to identify and limit the moats established by frontier companies. What works for Warren Buffett does not necessarily work for the wider economy.