Has Warren Buffett broken American capitalism?
The Oracle of Omaha’s investment style has been incorrectly blamed for the decline in investment and competition in the United States in recent decades.
The AFR – owned by Fairfax (ASX:FXJ) – recently breathlessly reported on various studies purporting to show How Warren Buffett broke American capitalism (subscription required). Now, like most value investors, I have the utmost admiration for Buffett and what he has accomplished over nearly 70 years so I perhaps I’m biased.
However, I think it’s a stretch to suggest his preference for monopolistic companies that can consistently raise prices while requiring little capital investment to maintain and grow their operations has ‘broken American capitalism’. And the real reasons for the decline in investment and competition in the United States in recent decades are far more nuanced – and more interesting – than suggested by this headline.
Rise of the intangibles We live in the era dominated by Facebook (NASDAQ:FB), Google, (owned by Alphabet (NASDAQ:GOOG)) and Apple (NASDAQ:AAPL), whose assets are primarily intangible rather than tangible in nature. Most of the ‘investments’ made by these companies (such as software development) are immediately expensed through the profit and loss account, and they have minimal requirements for the capital investment conducted by the US Steels, Fords and General Electrics which used to dominate the US economy.
One of the studies referenced in the article finds the rise of intangibles explains around 25–30% of the decline in investment over the past two decades. The tendency of the Facebooks, Googles and Apples to operate in winner-takes-most or winner-takes-all markets is also a major factor in reducing competition, while globalisation and free trade have also played a part in reducing investment in the US. Finally, increased institutional cross-ownership and short-termism that emphasises short-term returns to shareholders rather than investing for the long haul was found to be another factor. Other factors However, I think there are other factors that haven’t been considered.
For example, short-term returns to shareholders via dividends and buybacks are much easier to fund in our current era of artificially low interest rates, which was also the case before the global financial crisis. Very low interest rates make it more profitable for businesses to use their spare cash and perhaps take on more debt to buy back stock rather than expand their operations.
In other words, it’s not despite but because of low funding costs that investment has declined. Below a certain point, further reductions in interest rates have virtually no impact on the investment decisions of companies. This is counterintuitive but it makes sense if you disagree with the idea that company boards are full of mindless automatons just blindly following the Federal Reserve policy decisions and instead are comprised of people with minds of their own who consider the secondary and tertiary effects of the Fed’s decisions.
Another factor is a tax code which encourages US corporations to keep cash generated from foreign earnings outside the US, as they are subject to punitive taxes if repatriated (I’m not making this up!). This problem has become larger as US companies have expanded around the world and their share of earnings from foreign sources has increased.
Why would a US company invest in a new factory ‘stateside’ – and incur US corporate taxes on the funds repatriated back to the US to do so – when it could instead avoid this tax by using its free cash to build the factory outside the US? Finally, I’d suggest increased regulation, beginning with Sarbanes-Oxley under President Bush and really getting going under President Obama, is another major factor. More regulation tends to benefit the larger, established firms, as they can more easily spread the fixed costs of regulation over a larger revenue base.
This makes is even harder for smaller competitors to compete with them, as well as making it more difficult for new entrants to enter the industry in question. It also affects investment decisions, as the costs of regulation need to be considered when deciding whether to build a new factory, a new drug laboratory or, heaven forbid, a new nuclear power plant. Perhaps I am wrong here but I’d like to see these factors analysed by academics and journalists. But I guess it’s easier just to blame Warren Buffett instead.