Notes on The Myth of Capitalism by Jonathan Tepper

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Trade Idea:

Go long concentrated industries and go short unconcentrated industries.

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if you take a variety of inputs into our leading indicator for wages it would
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tell you that wages should be rising considerably the thing that was bugging
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me though is that clearly our leading indicator for wages was wrong and I
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didn’t know why the lack of vitality the lack of innovation and low productivity
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all of these things The Economist’s are documenting coming from essentially
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increasing industrial concentration
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at very perception what we try to do is to help hedge funds family offices asset
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managers essentially look ahead and what we’re trying to do is to develop leading
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economic indicators leading liquidity indicators and tools that sort of tell
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us where the economy is going whether it’s the US economy or the Chinese
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economy but even more importantly where our credit spreads going where it’s the
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yield curve where our stock prices you know these investors ultimately it’s not
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that they don’t care about the economy but rather they actually care about sort
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of you know where their investments are going and so a lot of the way that the
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leading indicators are built is based on some historic relationships you know we
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haven’t reinvented the wheel but there’s also an enormous amount of additional
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research and work that we’ve done and the only reason that we care about this
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is to try to find tradable investment ideas so something that might lead us to
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conclude that we have a disagreement with the market and therefore a variant
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perception and where you can find essentially a high risk reward short or
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long and then sometimes you know if our tools confirm what the market thinks
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then those tend to be more momentum trades but at least it’s good to have an
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objective set of tools that tell us where things are going I was a
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proprietary trader many years ago and what I wanted to do is to have tools
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that would help me create a repeatable robust and scalable process and there’s
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the assumption that you know someone has a crystal ball and that they might be
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able to tell you the future and the approach that we’ve adopted it variant
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perception is certainly there many people who have you know deep insights
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but the the best way to try to create a repeatable process is effectively to
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find tools that work across cycles if we’re trying to create these tools that
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provide a lead on asset prices in the business cycle
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one of the things that had been troubling me the most in the past few
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years had been a particular leading indicator for wages in the United States
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and so if you think about a variety of economic data some are coincident
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meaning they tell you about today and if you used a driving analogy it’s like
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looking out of you’re sort of you know side window and it tells you sort of you
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know where you are and that’s like retail sales or industrial production
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they tell you about today if the economy is doing well people are buying if the
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commies didn’t well industrial production is grind then there are
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things that I know obviously what we focus on are leading indicators that
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tell us a bit about the future one of the things that is a lagging indicator
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is inflation or wages so typically if you’re running a supermarket you have a
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good month or two of sales you don’t start hiking your prices immediately you
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wait to make sure that the demand is there that you know you can raise prices
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so the key thing that I was looking at was wages and wages lag the economic
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cycle considerably and so you know one because wage negotiations tend to happen
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at the end of the year often you know when you go to talk to your employer and
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like well how is my year do I get a bonus you know obviously it’s even more
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exaggerated in the financial industry and the hedge fund industry where you
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know how much your entire pay depends on your year-end bonus but throughout many
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industries as well that are lower paid it’s an annual thing and so therefore
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wages lag the economic cycle and over the past couple years everyone’s been
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saying well wages are very low don’t worry about it
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you know eventually they’re going to pick up because they like the economic
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cycle considerably and it’s been sort of like waiting for godot where the ink you
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know that the labor market has gotten tighter so if you’re looking at initial
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unemployment claims in the United States basically they’re lower than they were
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going back to 1973 and at the same time if you look at it as a percentage of the
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total workforce it’s the lowest percentage ever so your chances being
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fired in the United States right now we’re practically insignificant now that
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would imply that there’s this tremendously tight labor market and
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therefore the balance of power should be shifting towards workers and
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historically if you take a variety of inputs into our leading indicator for
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wages it would tell you that wages should be rising considerably some of
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the things we look at our surveys like the NFIB survey which is the National
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Federation of Independent businesses and you know they ask them they say do you
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expect to raise wages you know anytime soon and most of them said that they did
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also is hard to find workers most them say it’s hard to find workers those
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things tend to lead the wages historically going back decades yet at
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the same time you know I kept on looking at these charts and wages weren’t going
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up you know even when our leading indicator was going up and it’s worked
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almost perfectly for four decades and and if you plot it against most of these
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inputs that I’m telling you it’s also worth perfectly so I don’t mind being
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wrong I think that when you’re wrong off and that’s where you can actually learn
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quite a bit if you can analyze sort of why you’re wrong and you know where you
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can you can fix things or what new insights or understanding you might be
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able to have the thing that was bugging me though is that clearly our leading
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indicator for wages was wrong and I didn’t know why and so one of the things
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that I wanted to do is to go away and do loads of research that variant we focus
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on cyclical stories you know of the economy we don’t spend an enormous
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amount of time on unstructured big structural breaks but we do pay
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attention to them and so one way instead of doing a lot of work on the structure
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of the US economy and corporations and it was became quite evident after
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reading hundreds of academic articles and doing lots of our own independent
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work that one of the biggest changes that’s happened in the US economy
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directly affects wages
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the answer to the puzzle that we had is you know about why our wage is not
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rising is essentially that the US economy is becoming increasingly
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concentrated and by concentrated I’m talking about industrial concentration
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so if you’re looking at an industry you know you have a perfectly competitive
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industry let’s say we have 100 companies each one with one percent market share
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right and that’s like a perfectly competitive industry no one company can
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dominate the industry no one company can raise prices you know essentially that
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in do you go back to economic textbooks that’s what’s referred to as perfect
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competition everyone is essentially a price taker the other extreme is
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obviously one company which has 100 percent market share that’s a sort of
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classic textbook case monopoly now these don’t tend to exist in in real life for
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a variety of reasons and where they do they tend to be regulated so like you
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know a water utility will provide water to a hundred percent of the customers in
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a given City and so there are as it turns out of course there are many
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industries in the United States and around the world that are almost
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monopolies or believe it or not that actually appear to be oligopolistic
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where you take the whole United States and you carve it up geographically and
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you defined for players or five players but you find out actually that each one
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has a local monopoly and so this matter is an enormous amount because if you
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look over time the proportion of workers that are in unions has been declining
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and as at the same time we’ve seen an increase in concentration among
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companies so if you are a worker in a hospital for example a nurse and you
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live in a town that has only one hospital you have a diffuse set of
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nurses for example in doctors negotiating against one hospital
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provider likewise there many other industries where you know if you are a
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telecoms worker and you’re working in a a town that has one cable system you are
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negotiating for wages against one employer and this is also true for
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example if you’re looking at Airlines many airports in the United States or
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what are known as fortress hubs so if you take Charlotte North Carolina it’s
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close to ninety percent I believe it’s um American Airlines right and then you
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look in Atlanta which has Delta right and so you start going around the
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country and while it appears that there is this a very
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market what actually happens is that you have these sort of local monopolies and
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this to a large extent explains why wages have been weak there’s quite a lot
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of research that’s been done and you know that looks at online job posting
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and then pairs that to industrial concentration by city and county and
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what’s very clear is that if you live in a town and this generally rural because
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obviously if you’re in a big city you have more choices in general for who
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you’re going to work for but it’s so the rural economy generally has an in that
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just rural but sort of smaller cities relative to big cities have a lot less
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choices and therefore tend to have much lower wages due to the fact that they’re
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generally facing off against one big employer and this is very true
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certainly in towns that you know have one major poultry employer whatever it
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might be this clearly has enormous implications one for for wages in the
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1970s there were quite a few reasons for the inflation spiral one of them
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happened to be the wage price spirals inflation is going up then workers
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demanded wage increases if we’re just increases were going up then companies
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started passing them on as costs and so you ended up with this wage price spiral
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so there’s sort of a macro element to the story in terms of why we know what
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we’re saying so what we’re saying on the on the price level and the other is the
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micro story for long short investors what what are the implications in terms
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of do you want to be going long or short certain industries or certain companies
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what’s fascinating is that if you’re looking at the sort of top-down question
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right which is where should inflation be and where should bond yields be they’re
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they’re two ways that you can look at it an investor in New York I was a client
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put it this way to me he said they’re straight to two types of sort of
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monopolies or concentrated industries one is the sort of Giants kicking
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midgets in the head and the other is Titans facing off against Titans so one
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has very clear implications for prices I mean either going up so this is
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generally the Giants kicking midget in the head if you are the local cable
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company and you know you’re facing off against all these diffuse consumers you
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can afford to hike prices on the other hand what often happens is you’ll find
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industries where like for example Walmart faces off against for you know
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agricultural you know meat or you know soft commodities producers and you end
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up with sort of Titans facing Titans and this is something that happens often and
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so what what happens there is not the pricing necessary go up but rather that
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the supplier gets squeezed tremendously and it’s unsurprising that bankruptcies
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among farmers over the last twenty thirty years have completely skyrocketed
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and that’s partly because while it appears competitive in the sense that
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you have so you know three hundred million consumers and then you have sort
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of two million farmers and you’d say well that’s extremely diffuse this is
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like the definition of perfect competition it’s a very sort of an
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hourglass structure where there are four firms that meet in the middle whether
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it’s archers Dan’l middle and Bunge Cargill you know and so you have the
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hourglass figure whether it’s on the softs whether it’s on the meat side you
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know whether it’s produced in the field and so increasingly more and more of
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these industries are concentrated and it really does depend on what kind of
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industry you are whether going to see price increases or whether you’re going
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to see squeeze on suppliers and squeeze on workers but invariably the worker
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gets squeezed and that was really sort of the origin of the question what’s
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interesting is that often the companies that are monopolies don’t necessarily
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appear to be monopolies so for example if you take many industries that appear
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to be oligopolies that would be you know four five six players generally it’s for
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when you get to up to six players it tends to be more competitive but for
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players what happens is often as I mentioned before you have these local
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monopolies develop so for example take something like the funeral industry the
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phenol industry in the United States about 30 percent of it is in the hands
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of service corporation most people obviously are in great distress when a
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family member dies you know it’s a horrific event and so they don’t tend to
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be shoppers you know they’re not going to go around and comparison shop for
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funeral services for a loved one and so because of that if you can be the
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funeral home it’s located in a place that it doesn’t have much
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competition you know you’re going to get an enormous amount of pricing power
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unsurprisingly service corporation has prices are about
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thirty percent higher than independent funeral homes and so these are very
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clear examples where markets may appear to be essentially diffuse and perfectly
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competitive but in fact have a lot of local monopolies Warren Buffett is the
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ultimate monopoly man you know he’s certainly a genius he’s very very smart
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when greatest investors of all time but if you start looking sort of over all
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his investments from the outset not till later now clearly Berkshire Hathaway
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where the name comes from was a terrible investment you know it was a New England
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mill but once he started moving outside of that and learned some of his first
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lessons he was essentially buying local newspapers and he would often run like
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there would be like a weekly newspaper and maybe a weekend edition and he would
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drive out the other other newspaper from from business and then he would have a
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local monopoly and four years before the internet that was basically a license to
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print money likewise one of his first investments
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was you know in the ABC television company uses capital cities and you know
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it was very similar you know you paid for the asset you know the cost appeared
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high but it was just depreciation over time and you know these were essentially
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local monopolies and often you know local duopoly and oligopolies he’s
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almost always bought industries when they’ve gotten down to about four
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players so he bought Burlington Northern when the railroads got down to four
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players you know so when the staggers act and deregulated the US railroad
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industry you know there were about 31 I believe railroads and then over time you
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had said of all the railroads started converging and it got down it was like
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you know March Madness it got down to the Final Four and sure enough that’s
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from Buffett bought one interestingly same thing happened with the airlines
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the airlines were allowed to merged they got down to four players and Warren
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Buffett not only bought he didn’t buy one he bought all four of them right so
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he wasn’t making a bet on a company he was making a bet on an industry in a way
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that when he had said that capitalism would have been better off if the Wright
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brothers had been shot down you know and so it gives you a sense of sort of how
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Buffett thanks you know the oligopoly is a monopoly is very powerful
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when industry by industry identifying the stocks that had monopolistic power
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it took quite a long time because there’s it’s not immediately obvious how
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to do it you know you can for example look at higher returns on capital there
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many companies that might exhibit higher returns on capital but might it might be
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brief or temporary and then some companies that do have pricing power and
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I do have monopoly power often essentially don’t appear so from the
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outset but when you qualitatively start looking at it you can then see where the
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the pricing power of is
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there’s a paper that I highly recommend reading it’s easy to find online it’s
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everywhere it’s by Gustavo go to you and GRU LLO and he is a professor at Rice
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University and he wrote a paper called our industries becoming more
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concentrated and what’s very interesting is that he noted that if he went long
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the concentrated industries and short the unconcentrated industries you would
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achieve a 9% out performance per year so that has very clear implications for
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equity long-short managers we’ve identified almost all the companies that
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would fit the concentrated industry we’ve not yet written a short report on
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the unconcentrated industries but that’s probably a second step and what’s
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interesting is then you can put them into a a portfolio now obviously you
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could throw them all in this it’s not an optimal way to wait to do it necessarily
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because that clearly what you would prefer to do is to buy cheaper ones or
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buy better ones and that is where some of these sort of secret sauce comes in
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but the implication is pretty obvious from bullion’s work and from our work
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that this that concentrated industries can produce higher higher performance
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and in there clearly is something about moats you know we’re Buffett talks about
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it some of the moats are our business related so you have for example you know
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Buffett’s talked about low-cost providers and Walmart and he once said
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it was mistake that he did not buy Walmart early on but he has brought
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other low-cost providers you have the network effects those often can
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essentially help create conditions that might encourage monopolies or duopoly so
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network effects for example are very evident if you’re looking at sort of
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PayPal you know a payment systems it seems true with Visa or MasterCard you
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know before they were floated obviously the banks owned them collectively and
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the reason for that was that it made sense to have a common resource you know
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where you wanted to have a network for payment and you know I don’t think that
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their manager is sitting around saying I want to buy monopolies and that’s their
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invest and philosophy but rather obviously it’s
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a very key part of it which is that you’d like to find companies that have
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less competition so I don’t think anyone would necessarily go out and say you
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know give them monopolies are usually viewed as being bad people probably
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wouldn’t admit that but certainly from an investment standpoint they’re quite a
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lot of funds out there that that do that
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inevitably there is a pendulum back and forth and you can see this in history
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that I think this will change the question of course is one how quickly
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does change happen and you know how does the political mood shift if you look at
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American history you have to go back to essentially the the Gilded Age the time
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of the so-called robber barons I mean the term itself robber baron comes from
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medieval Europe where you had barons who had roads going through their you know
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lands and they would charge people for going on the roads without actually
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providing any improved roads and in a way the funny thing is the the entire
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basis of monopoly investing if you will for a long short fund is that what
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you’re trying to essentially own a toll road and so the it’s funny that the term
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robber baron comes from the sort of toll road collecting idea for for long short
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investors but if you go back to the robber barons that in 1890 a Sherman Act
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it took quite some time once the Act even been passed for there
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to be effective prosecutions and it wasn’t really even until 21 years later
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that Standard Oil was broken off in 1911 and so the question is now one you know
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how did we get where we are and how it’s going to change so for four decades
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particularly after the late 1930s antitrust was vigor very vigorously
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enforced and there were you know most industries were not very concentrated
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what you had was Roosevelt had appointed a head of the Antitrust Division very
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aggressive the 40s and 50s presidents continued this and it was only really in
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the late 1960s and 70s Robert Bork in the Chicago School started attacking
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essentially the idea of antitrust arguing that efficiency is better and
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consolidating companies getting bigger companies can create more consumer
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welfare and okay and then the the Sherman Antitrust Act and the
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Clayton Act the only real reason they existed was because they might raise
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prices on people and therefore if you could have a monopolist or you could
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have a do a list that might be more efficient and give you lower prices then
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who cares about any of the other considerations and of course the
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consumer welfare doctrine is nowhere in the original acts it’s basically a sort
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of a revolution and in thought and but everyone bought into that and you know
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Bork were a highly influential book called neon tetras paradox and so when
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Reagan came into power the antitrust in a way had possibly gone too far in the
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70s where you know to Los Angeles supermarkets couldn’t merge with each
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other because they might increase their market share by a percent or two which
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was you know probably taking it too far so as a pendulum
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things had gone from no antitrust you know in the 1880s to essentially quite a
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lot by the 1930s that stated for a while and then it went essentially from the
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early 1980s it’s now moved in the exact opposite direction where once Reagan
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appointed people who bought into vorks idea you know any merger could go
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through and since the 1980s what we’ve had essentially is every single decade
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has had a merger wave and which is extraordinary if you think about the
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first merger wave was a strangely after the Sherman Antitrust Act was passed
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because it wasn’t really enforced so from 1918 92 1904 you had a huge merger
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wave then the next one was the 1920s you know everyone stock market
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rebuilding companies or button people were buying each other and and then you
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had essentially the and these were all horizontal mergers meaning the you know
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competitor a buck competitor be in the same industry the 1960s because they
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weren’t actually enforcing the antitrust laws
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you had a merger wave of creating conglomerates so if you couldn’t buy
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your direct competitor because of antitrust enforcement you’d have crazy
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things like Gulf Western where you’d have an oil company buying a Hollywood
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studio you know and you just had the most ridiculous conglomerates put
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together you know wanting to merge but not being able to by their direct
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competitors so these all got broken up in the 1980s and 1990s in these were
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like ITT for example and others and so when threatened came in in 1980 they
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changed the merger guidelines and then every single decade has had a merger
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wave where competitors have slowly been you’ve been there
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field down till now you’re down to a very very few so as you can see from
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history it takes a very long time to move the pendulum in either direction
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and I think that unfortunately it’s going to take some time it’s going to
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take I think it’s starting to happen a bit on the Democratic side I suspect
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that Republicans as well you can see this with some conservatives and
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capitalists you know bizarrely in the Chicago School which is historically
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been the most Pro merger free market for stroud they’re recognizing that there
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are very bad consequences that come from high industrial concentration and it’s
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not just low worker wages is actually less economic dynamism so there’s quite
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a lot of research that ties fewer startups in all areas you know including
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technology they’re just fewer startups and so the the the right or the sort of
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pro-capitalist side is also recognizing that it’s just not good to have two or
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three companies or even one completely dominate an industry you end up with
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less innovation and you end up with less flexibility less creation of new
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companies so I suspect that the left and the right will end up abandoning
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together eventually for different reasons left motivated by higher wages
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the right motivated by more economic dynamism and you’ll end up with merger
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guidelines being changed perhaps new acts some of this has to do with I think
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the digital monopolies if you’re looking at Facebook and Google and others you
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can see that people are starting to wake up the fact that one player owns all
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your digital information and so all this that I’ve been talking about essentially
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is starting to play out and the national consciousness and I think that that’s
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going to start leading to a change we’ve written these reports for variant
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clients I’ve started writing a book and you can go to the website it’s a myth of
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capitalism calm I’ll be doing further blog posts on all the various issues
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that I’m outlining here not so much from the investment investing angle more from
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the social angle from the historical angle looking at these very very big
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issues and so I do think that things are going to change but I think that this
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process is a long one and I think that you’re going to start seeing it play out
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essentially in you know the department justice FTC but also obviously
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in the election cycle that this is not really purely a u.s. phenomenon I think
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that perhaps it’s most exaggerated in the u.s. you know because it’s a very
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it’s one of the largest markets in the world by GDP but you see this in many
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other countries and the the strange thing is often you see it even more in
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smaller countries so if you think that for example the Australian banking
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situation that’s an oligopoly right they earn extraordinarily high returns
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because there’s almost no competition likewise if you start you know if you’re
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in the UK you can see that there are very few players in many industries in
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some industries these are obvious monopolies that are regulated you know
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whether it’s telecoms in some of the European countries and so to that extent
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they’re they’re reined in and controlled but in many other countries you have
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oligopolies and Wobblies that essentially are not reigned in not
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controlled and you see a very similar dynamic that you see in in the United
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States and so the problems in the United States which is the lack of vitality the
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lack of innovation and low productivity all of these things The Economist’s are
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documenting coming from essentially increasing industrial concentration or
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evident in other countries and you know this this is very true if you’re looking
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at Mexico if you’re looking at Russia and unfortunately it is highly tied to
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income inequality which is obviously getting to be a much bigger issue in our
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time and I think this in part explains why you’re seeing a rise of third-party
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candidates sort of outside of the two major parties in most countries people
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are simply watching you know every day if you pay money to these monopolies and
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oligopolies money’s going out of your pocket into their pocket and this is
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effectively a form of Taxation but it’s happening and people recognize this feel
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that somehow things are wrong and then mysteriously are voting for third
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parties you know and obviously the political system itself is a form of
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duopoly in most countries you know so they’re there in a way we revolt against
27:08
this political and economic sort of oligopoly and duopoly and I think that
27:12
it does answer quite a lot of those questions
27:16
I think the technology clearly can help break up some monopolies but the paradox
27:26
is that if you’re looking at technology often it actually entrenches monopolies
27:32
and oligopolies and you know part of that is that before
27:34
you know if you wanted to take over many many towns you know you had to
27:38
physically locate a store there or a service point in the digital world you
27:43
can achieve scale much much faster and and therefore locking people in to your
27:48
program or to your software and you know your your web platform means that you
27:53
can generally achieve network effects and economies of scale much faster and I
27:58
think that’s one reason why a lot of the monopolies are concentrated in the tech
28:03
sector and you know they’re clearly not just the tech sector but very definitely
28:07
I think scale and technology rather than break down barriers actually helps erect
28:13
them by allowing for faster scaling under Network effects
28:23
what’s very interesting is if you’re looking at the asset management business
28:27
the investing business which everyone who subscribes to real visions in you
28:33
know whether whether you’re providing the the product or whether you are an
28:36
investor and consuming the product you know investing in a variety of funds or
28:42
even stocks and what’s fascinating is you’ve seen this increase in
28:46
concentration in other industries where fewer and fewer players exist and so for
28:50
example like if you’re looking at u.s. listed stocks they declined by 50% since
28:54
1997 so you’re getting all this concentration on the industrial side but
28:58
in the asset management side you’re seeing a similar industrial
29:01
concentration some of it for example in the hedge fund side comes from
29:04
increasing regulation and scale so like you know the top 100 funds control
29:08
almost all the assets in the hedge fund world you know people it’s very hard to
29:13
start smaller funds but interestingly on the passive versus active side you know
29:18
the very big passive players are getting more and more of the market share and in
29:24
theory this is great because everyone’s paying fewer fees I mean it’s just bibs
29:28
the problem with this of course is that you end up looking at an industry and
29:32
before I was saying Buffett’s buying all the airlines well it turns out that all
29:35
the passive guys are buying all the airlines too and they’re buying every
29:38
other industry right and they have no interest in promoting one company to try
29:42
to gain market share to compete they would far prefer to see no competition
29:46
and have no interest in sitting on the boards or voting their shares and
29:49
achieving a better outcome for any particular company that’s just not the
29:52
way they operate right so you have this increasing concentration on the
29:57
investment side then with further effects that encourage further
30:01
concentration on the operating side of companies so in under the laws you know
30:09
JP Morgan used to buy up shares and you know trying to control industries
30:13
whether it’s buying all the railroads that competed with each other and so
30:16
that was outlawed now obviously there are some exemptions for passive
30:20
investing where one fund can own in every railroad and it’s not a problem
30:24
but quite clearly it’s the same effect you know where you have essentially a
30:28
few large players whether it’s Blackrock and Vanguard and others that are
30:31
essentially now the dominant owners in the US economy
30:35
with no interest in encouraging any competition between their holdings you
30:39
know and I think that it is sort of going back to the days of of JP Morgan
30:47
there’s an enormous amount of historical detail which i think is fascinating you
30:52
know it’s so we have like a report on the investing side at fair and
30:57
perception if you have any interest in the history the ideology and all the
31:00
rest that goes with the the pendulum back and forth and where things might be
31:04
going on the myth of capitalism which will be coming out probably later this
31:07
year and so there’s there’s quite a lot there and they’re just true truly
31:12
unexpected paradoxes so when the US came into Europe after World War two you had
31:16
essentially the Potsdam agreement they wanted to dakara lies and decentralize
31:20
the u.s. effectively exported its antitrust ideas to Europe and wanted to
31:25
make sure that was a critical part of European reconstruction and it’s funny
31:28
that the u.s. now forgotten about antitrust completely and the EU is
31:32
actually the one making all the noise right so it’s funny how sort of history
31:35
often goes in swings and roundabouts but it’s absolutely fascinating area you
31:40
know which is one I think fun to read about and two obviously has enormous
31:43
investment implications on the macro side
32:36
you