Competitive Dynamics In Industrials

As a natural born capitalist I embraced from the youngest age Adam Smith’s economic theories. Self-interest acts as an economic motivator. That motivator is held in check by competition through free-market policies. Both self-interest and competition complement each other to produce wealth through the ‘Invisible Hand ’. How could anyone possibly disagree?


THE MAXIMUM COMPETITION DOGMA


According to the traditional economic theories, the optimal level of competition from an economic efficiency point of view is perfect, i.e. maximum competition. It is like a dogma. Industry participants must compete for all the resources alongside the entire value chain. They must capture the hearts and minds of suppliers, talented employees, customers, governmental institutions and capital providers - relentlessly. Only the fittest survive, it is a matter of natural selection.


Margrethe Vestager, the European Commissioner for Competition, explained in simple terms in a recent Ted Talk why such competitive environment must be enforced: ‘The temptation to avoid competition is powerful. It's rooted in motives as old as Adam and Eve: in greed for yet more money, in fear of losing your position in the market and all the benefits it brings. And when greed and fear are linked to power, you have a dangerous mix.’[…] Competition rules can [make] sure that greed and fear doesn't overcome fairness.’


THE NEGATIVE IMPACT OF COMPETITION ON BEHAVIOR


And yet there is little doubt that the optimal level of competition is shy of maximum competition. Here is what the literature has to say about the effect of competition on behaviors as I synthesize various thoughts and readings (sources below):

  • Competition fosters risk-taking: Various studies establish a clear correlation between the degree of competition and industry participants’ risk appetite. They include a 2010 paper by the Bank of Spain highlighting the inverse correlation between market power and risk-taking in the domestic banking systems, which by extension can be linked to some of the origins of the Great Financial Crisis. More generally, experiments demonstrate that the appetite for risk amongst competing individuals increases as the anticipated pool of “winners” decreases. In the extreme case of a “winner-takes-it-all” opportunity (e.g. commercial flight to mars), the only rational choice for industry participants is simply maximum risk taking

  • Separately, competition drives short-termism. In a highly competitive environment with low barriers to entry, any hard-won competitive position can be easily challenged. Under these circumstances, companies are led to focus on implementing strategic measures allowing them to survive in the short term since there may not be any long term. This is often expressed in the hurdle rate which is applied when making investment decisions. Any corporate using a hurdle rate which is materially above that of its cost of capital de facto values short term cash flows more than it should relative to long term cash flows. Perniciously, a high hurdle rate may not allow for the selection of the most value-creating projects. The same comment can be made about the need to cover the cost of capital as early as three years post acquisition, which is a common M&A criteria

Together, risk-taking and short-termism sow the seeds of unethical behavior, which is by definition socially damageable if not straight on illegal (from child labor to earnings manipulation via corruption). As a result, maximum competition raises the need for stringent rules and regulation to prevent systematic misconduct (e.g. Sarbanes-Oxley after Enron/WorldCom) with all the negative consequences identified in ‘Rules or Discretion?’ earlier this month.


In conclusion, it seems to me that instead of there being an indisputably positive correlation between competition and economic benefits, there is more likely a bell curve: if limited, competition causes resources to be misallocated since unfairly captured by mono- or duopolists. If too elevated, competition drives risk-taking and short-termism which is inherent in our capitalistic model to extreme, which then leads to the misallocation of resources as well.


IMPLICATIONS FOR THE DIVERSIFIED INDUSTRIALS SECTOR


Competitive intensity is set to increase in Diversified Industrials in two distinct ways, in my view:

  • For a number of industry segments, commoditization will continue to intensify as globalization stays on its unstoppable path. Furthermore, many pieces of equipment will lose some relevance as systems and solutions driven by the Industrial Internet of Things take off, in addition to distributed energy or electrification trends. It will be vital for industry participants to allow maturing activities to consolidate, especially as some of them will be at risk of obsolescence. Else the increase in competition may led to some of the counter-productive behavior described above. Critically, competition authorities around the world will need to take a more dynamic, holistic and thus more lenient approach to antitrust investigations

  • On the other end of the spectrum, the fourth industrial revolution may bring with it some “winner-takes-it-all” opportunities calling for maximum risk-taking in a highly competitive environment. This is especially true as such market opportunities can be targeted by many different types of participants: established Diversified Industrials companies, vertical software players, larger tech companies or even new entrants

IN CONCLUSION


The years ahead are set to see an increase in competition across vast segments of the Diversified Industrials sector. The natural response from market participants might lead to more risk-taking and short-termism; definitely more paranoia; hopefully no scandals with rules and regulation as a response thereto; and some consolidation in mature segments to respond to this new state of affairs, noting that what might not be deemed to be achievable today from an antitrust perspective may become possible tomorrow.


Finally, the wedge between mature and dynamic, higher tech industrial segments will go deeper. This will call for a comprehensive review of corporate asset portfolios. How exciting!


Sources

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