“I like a little competition, but I should rather have cooperation”.
- J.P. Morgan
“Untermeyer: But what I mean is that the banking house assumes no legal responsibility for the value of the bonds, does it?
Morgan: No sir. But it assumes something that is still more important, and that is the moral responsibility, which has to be defended as long as you live”.
One of the best reads about the old-fashioned concepts of “gentlemen’s” banking is J.P. Morgan’s testimony to the Pujols Committee of the US House of Representatives in 1912. I personally think we could have avoided many of the problems in the 2008-2009 market crash and subsequent credit crisis if more individuals had taken the time to read it earlier in their career.
As one reads Samuel Untermeyer’s grilling of Mr. Morgan, one thing becomes clear very quickly. Long before Warren Buffett gave us the idea of “moats” or Porter wrote his seminal work “On Competition”, John Pierpont Morgan was the first investor to truly understand the concept of wide-moat investing.
His view had less to do with modern definition of moats (“A type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit”.)[1] and more to do with investing in a corporation with limited competition and cooperative agreements by market leaders. He believed that not only the moat created by size and economies of scale was necessary (such as US Steel), but the moat provided by the “gentleman’s agreement” to avoid a competitive rush to the bottom was equally vital. Morgan had seen this behavior all too clearly in his efforts to refinance, restructure, and sell syndicated debt instruments of the railroad industry.
The latter type of moat is rarely seen today. With the breakup of the great trusts in the early 20th century and greater enforcement of anti-trust law, the ability to create a wide moat through agreed-to non-compete agreements are hard to find. But they do exist.
Pharmaceuticals have long used pay-to-delay agreements with generic drug manufacturers. When a pharmaceutical’s branded product (say Lipitor) goes off patent, generic manufacturers can market generic equivalents at 75-80% below the branded product’s pricing. In general, when the product goes off patent, the pharmaceutical might see their product’s annual sales drop by up to 90%. It’s obviously in the company’s interest to extend patents or side track generic manufacturers. In the latter case this takes shape in the form of a pay-to-delay agreement.
Many believe this type of action went the way of the dodo sometime in the last century. That would be flawed thinking. For instance, in January 2017 the FTC (Federal Trade Commission) refiled a complaint[2] and a proposed stipulation order in federal court to resolve charges that Endo Pharmaceuticals (US and ex-US) violated the antitrust laws by using pay-for-delay settlements to block generic drug manufacturers from producing a generic version of its two top-selling branded drugs, Lidoderm and Opana ER. Endo entered into such an agreement in order to preserve its monopoly profits. But Endo wasn’t done there. The FTC also refiled charges against Watson Laboratories - and its former parent - Allergan, for illegally blocking a lower-cost generic version of Lidoderm when it entered into a pay-for-delay agreement with Endo. Two major generic manufacturers had now voluntarily taken themselves out of the running. Their benefit? A cash payment from the pay-to-delay agreement to share profits from the much more profitable branded product sales.
Morgan would have understood these agreements immediately. There isn’t a moat much wider than one that willingly prohibits your competitor from competing and maintains your monopoly of your product sales. But it must be said this would have gone a little too far for even Morgan. In his testimony, the following interaction summed up his view on competition as well.
“Mr. Untermeyer pointed out that some of the members of the Morgan firm were not only on the board of directors of other banks but of the executive committees as well. Mr. Morgan finally said that even assuming that they did know the business of competitors he could see no objection to it.
Q. Do you think that promotes competition?
A. It does not prevent it.
Q. You are opposed to competition, are you not?
A. No, I do not mind competition.
Q You would rather have combinations, would you not?
A. I would.
Q. You would rather have combination than competition?
A. Yes
Q. You are an advocate of combination and cooperation as against competition, are you not?
A. Yes. Cooperation I should favor.
Q. Combination as against competition?
A. I do not object to competition either. I like a little competition.
The Endo pay-to-delay agreements we can assume would have violated Morgan’s acknowledgment that a little competition is a good thing. Yet overall, I think Morgan would have heartily agreed with the thinking behind such agreements.
So what does this have to do with value investors? First, the characteristics of Morgan’s investments would be called “compounding machines” in modern parlance. The combination of little competition with combination was very successful indeed. If it was successful for Morgan, then why not future investors? Second, Morgan really can’t be called a monopolist. He looked for companies where the competitive advantages were predominantly on his side. The key here is “predominantly”. Morgan wanted the dice to lean his way. But isn’t that what all investors want? You can increase returns when you lay down the bets when the odds are in your favor.
I would suggest there are two key learnings from Morgan’s idea on limited competition.
Morgan’s Ideas Were a Precursor to Modern Day Value Investing
Investing in companies with wide moats, strong balance sheets, generous free cash flow, steady growth, and operating with little/no competition were the characteristics of Morgan’s investments[3]. These attributes seem eerily similar to a certain guru in Omaha. While achieved through actions outlawed in today’s financial markets, Morgan’s concepts of a good investment created a foundation for future successful value investors. Morgan really didn’t see this as anything radical in his approach. To him, stock certificates were quite real pieces of a business. He rarely cared about the stock price. But he watched his holding companies with an eagle eye. Great investors do the same.
Sometimes “A Little Competition” Really Helps….the Competition?
We all greatly admire Charlie Munger’s advice to “Invert. Always invert”. I would suggest taking a look at limited competition and cooperation from such a manner. For instance, Endo was able to keep its monopoly on its two top selling drugs through the pay-to-delay agreement. If you invert that, how does Watson look through the eyes of the agreement? It receives a tremendous amount of money for 5 years by doing nothing. At least Endo had to manufacture and market its drug. Which company made out better? Do both qualify as “wide moat” companies because of their pay-to-delay agreement? It all depends what angle you take in your assessment. I should note that these types of agreements aren’t just in the biopharma space. With a little bit of research, investors can monopolies, duopolies, and competitive agreements through out the market. For every wide moat company, take a look around and see how their behavior impacts other competitors and industry players. Sometimes value can be found in the strangest places by looking at things a little differently.
Conclusions
J.P. Morgan understood that a total monopoly wasn’t always the best investment for the long term (though it was pretty good results in the short term!) “A little competition” allowed several competitors to maintain strength and reduce the chance of a price war. It also reduced the risk of the government stepping in to break up monopoly-like syndicates. This process – which Morgan referred to as “gentleman’s banking and business” – was the first articulation of what would became wide moat investing. By inverting his thinking, investors can find value in the strangest of places. Considering the fact his company (after many changes!) remains one of the most influential businesses in finance, investors could do worse than following his advice.
[1] As defined by Investopedia
[2] More information can be found at the FTC website: https://www.ftc.gov/news-events/press-releases/2017/01/endo-pharmaceuticals-inc-agrees-abandon-anticompetitive-pay-delay
[3] These were relatively new ways to think about investing. During the period of from the Panic of 1873 to the Panic of 1893, 18,000 companies, ten states, and roughly 300 banks went bankrupt. Even the industry Morgan was intimately involved in – railroads – had 89 bankruptcies. Thinking about adequate capitalization and dividend coverage ratio was rare to be sure.
- J.P. Morgan
“Untermeyer: But what I mean is that the banking house assumes no legal responsibility for the value of the bonds, does it?
Morgan: No sir. But it assumes something that is still more important, and that is the moral responsibility, which has to be defended as long as you live”.
One of the best reads about the old-fashioned concepts of “gentlemen’s” banking is J.P. Morgan’s testimony to the Pujols Committee of the US House of Representatives in 1912. I personally think we could have avoided many of the problems in the 2008-2009 market crash and subsequent credit crisis if more individuals had taken the time to read it earlier in their career.
As one reads Samuel Untermeyer’s grilling of Mr. Morgan, one thing becomes clear very quickly. Long before Warren Buffett gave us the idea of “moats” or Porter wrote his seminal work “On Competition”, John Pierpont Morgan was the first investor to truly understand the concept of wide-moat investing.
His view had less to do with modern definition of moats (“A type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit”.)[1] and more to do with investing in a corporation with limited competition and cooperative agreements by market leaders. He believed that not only the moat created by size and economies of scale was necessary (such as US Steel), but the moat provided by the “gentleman’s agreement” to avoid a competitive rush to the bottom was equally vital. Morgan had seen this behavior all too clearly in his efforts to refinance, restructure, and sell syndicated debt instruments of the railroad industry.
The latter type of moat is rarely seen today. With the breakup of the great trusts in the early 20th century and greater enforcement of anti-trust law, the ability to create a wide moat through agreed-to non-compete agreements are hard to find. But they do exist.
Pharmaceuticals have long used pay-to-delay agreements with generic drug manufacturers. When a pharmaceutical’s branded product (say Lipitor) goes off patent, generic manufacturers can market generic equivalents at 75-80% below the branded product’s pricing. In general, when the product goes off patent, the pharmaceutical might see their product’s annual sales drop by up to 90%. It’s obviously in the company’s interest to extend patents or side track generic manufacturers. In the latter case this takes shape in the form of a pay-to-delay agreement.
Many believe this type of action went the way of the dodo sometime in the last century. That would be flawed thinking. For instance, in January 2017 the FTC (Federal Trade Commission) refiled a complaint[2] and a proposed stipulation order in federal court to resolve charges that Endo Pharmaceuticals (US and ex-US) violated the antitrust laws by using pay-for-delay settlements to block generic drug manufacturers from producing a generic version of its two top-selling branded drugs, Lidoderm and Opana ER. Endo entered into such an agreement in order to preserve its monopoly profits. But Endo wasn’t done there. The FTC also refiled charges against Watson Laboratories - and its former parent - Allergan, for illegally blocking a lower-cost generic version of Lidoderm when it entered into a pay-for-delay agreement with Endo. Two major generic manufacturers had now voluntarily taken themselves out of the running. Their benefit? A cash payment from the pay-to-delay agreement to share profits from the much more profitable branded product sales.
Morgan would have understood these agreements immediately. There isn’t a moat much wider than one that willingly prohibits your competitor from competing and maintains your monopoly of your product sales. But it must be said this would have gone a little too far for even Morgan. In his testimony, the following interaction summed up his view on competition as well.
“Mr. Untermeyer pointed out that some of the members of the Morgan firm were not only on the board of directors of other banks but of the executive committees as well. Mr. Morgan finally said that even assuming that they did know the business of competitors he could see no objection to it.
Q. Do you think that promotes competition?
A. It does not prevent it.
Q. You are opposed to competition, are you not?
A. No, I do not mind competition.
Q You would rather have combinations, would you not?
A. I would.
Q. You would rather have combination than competition?
A. Yes
Q. You are an advocate of combination and cooperation as against competition, are you not?
A. Yes. Cooperation I should favor.
Q. Combination as against competition?
A. I do not object to competition either. I like a little competition.
The Endo pay-to-delay agreements we can assume would have violated Morgan’s acknowledgment that a little competition is a good thing. Yet overall, I think Morgan would have heartily agreed with the thinking behind such agreements.
So what does this have to do with value investors? First, the characteristics of Morgan’s investments would be called “compounding machines” in modern parlance. The combination of little competition with combination was very successful indeed. If it was successful for Morgan, then why not future investors? Second, Morgan really can’t be called a monopolist. He looked for companies where the competitive advantages were predominantly on his side. The key here is “predominantly”. Morgan wanted the dice to lean his way. But isn’t that what all investors want? You can increase returns when you lay down the bets when the odds are in your favor.
I would suggest there are two key learnings from Morgan’s idea on limited competition.
Morgan’s Ideas Were a Precursor to Modern Day Value Investing
Investing in companies with wide moats, strong balance sheets, generous free cash flow, steady growth, and operating with little/no competition were the characteristics of Morgan’s investments[3]. These attributes seem eerily similar to a certain guru in Omaha. While achieved through actions outlawed in today’s financial markets, Morgan’s concepts of a good investment created a foundation for future successful value investors. Morgan really didn’t see this as anything radical in his approach. To him, stock certificates were quite real pieces of a business. He rarely cared about the stock price. But he watched his holding companies with an eagle eye. Great investors do the same.
Sometimes “A Little Competition” Really Helps….the Competition?
We all greatly admire Charlie Munger’s advice to “Invert. Always invert”. I would suggest taking a look at limited competition and cooperation from such a manner. For instance, Endo was able to keep its monopoly on its two top selling drugs through the pay-to-delay agreement. If you invert that, how does Watson look through the eyes of the agreement? It receives a tremendous amount of money for 5 years by doing nothing. At least Endo had to manufacture and market its drug. Which company made out better? Do both qualify as “wide moat” companies because of their pay-to-delay agreement? It all depends what angle you take in your assessment. I should note that these types of agreements aren’t just in the biopharma space. With a little bit of research, investors can monopolies, duopolies, and competitive agreements through out the market. For every wide moat company, take a look around and see how their behavior impacts other competitors and industry players. Sometimes value can be found in the strangest places by looking at things a little differently.
Conclusions
J.P. Morgan understood that a total monopoly wasn’t always the best investment for the long term (though it was pretty good results in the short term!) “A little competition” allowed several competitors to maintain strength and reduce the chance of a price war. It also reduced the risk of the government stepping in to break up monopoly-like syndicates. This process – which Morgan referred to as “gentleman’s banking and business” – was the first articulation of what would became wide moat investing. By inverting his thinking, investors can find value in the strangest of places. Considering the fact his company (after many changes!) remains one of the most influential businesses in finance, investors could do worse than following his advice.
[1] As defined by Investopedia
[2] More information can be found at the FTC website: https://www.ftc.gov/news-events/press-releases/2017/01/endo-pharmaceuticals-inc-agrees-abandon-anticompetitive-pay-delay
[3] These were relatively new ways to think about investing. During the period of from the Panic of 1873 to the Panic of 1893, 18,000 companies, ten states, and roughly 300 banks went bankrupt. Even the industry Morgan was intimately involved in – railroads – had 89 bankruptcies. Thinking about adequate capitalization and dividend coverage ratio was rare to be sure.
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