Increased regulation not always negative, says RECM
The long-term effects of new laws can be very different to what regulators initially intend. While increased regulation tends to reduce competition, which is bad for consumers, it can actually benefit established businesses by making it harder for competitors to enter their industry.
South African businesses face an array of regulations and compliance requirements that seems to increase every year. Examples include the new BEE codes, revisions to the Mining Charter, the effects of the credit amnesty on providers of credit, bans on tobacco advertising, a proposed ban on alcohol advertising and the effects of the Basel III phase-ins on banks and insurers.
“Given the choice, as consumers, we’d prefer less regulation rather than more,” says Linda Eedes, Senior Analyst at RECM. “Increased regulation tends to reduce competition and makes it more difficult for the average firm in an industry to compete. The higher costs associated with compliance also reduce profitability with only a few winners benefitting. Consumers usually fare better in a freely competitive environment.”
Regulation can also entrench the incumbents in an industry and make it difficult for new entrants to gain a foothold. “South African banks are a good example of this,” says Eedes. “It’s very difficult for anyone new to enter the industry given the high costs of complying with regulation. This gives the well-established ‘big banks’ a significant and sustainable advantage over new entrants.”
According to Eedes, when regulation establishes high barriers to entry in an industry that protect excess returns into the future, this can be good for investors however. “Even though we don’t like excessive regulation, a sustainable competitive advantage is one of the things we look for when identifying quality businesses in which to invest. The gaming industry is another example of a highly regulated industry where the incumbents have a significant advantage due to the high barriers these regulations create. This is one of the reasons we have invested in several gaming businesses including Sun International, Tsogo Sun and Grand Parade Investments.”
Eedes refers to the well-meaning legislation around the tobacco industry as a demonstration of the unintended consequences of regulation. “Sales reduced, as the legislation intended, and so did competition, but the firms that remain have become super profitable as a result. Compare that to the IT industry, which has very little regulation. The ability for new entrants to compete has been a boon for consumers – innovative new technologies positively affect their lives and prices continue to fall.”
Regardless of sentiment around proposed legislation, investors should focus on buying assets at very low prices relative to what they are worth, says Eedes. “This provides a buffer that can protect your investment if something goes wrong – including when a new piece of legislation unexpectedly negatively affects the business. Usually however, prices are low when the market either already knows about or anticipates the bad news, which means it’s probably in the price. Buying when there’s bad news is often not the easy choice – you need to follow your convictions and stay true to your investment process. But buying at low prices is the only thing that consistently shifts the odds of a good investment outcome in your favour.”
“We spend a lot of time and effort on understanding how the political and regulatory framework of an industry affects its long-term prospects”, says Eedes. “We can’t necessarily predict the outcomes (intended and unintended) of new legislation with any confidence. Nor can we forecast the new legislation that could be waiting in the wings. So we focus on what we can control – the price we pay for an asset.”
