Stock markets as indicators of economic sanity

Which is better?

One, where corporations compete “fairly and squarely” in a market of monopolistic competition. Or two, where corporations are oligopolistic, not quite successful in forming a cartel, but stifling competition enough so that there is little risk of loss or subnormal profits.

The first mode is good for the consumer, and imposes a tough discipline on managements. In the long run, corporations will on average earn high returns because of the drive to compete and innovate, although there will be big losers and winners. A few will go under.

The second mode is bad for the consumer, allows managements to be less than stellar, and yet corporations will earn high returns from oligopolistic pricing. Such returns are also more stable over the short run. In the long run, however, corporations in the second mode will lose markets to those in the first mode. Most of these corporations will not survive head-to-head competition from corporations in the first mode.

In the short run, corporations in the second mode will likely attract high price-earnings (P-E) ratios as many investors focus on the near term and fail to anticipate that most of these corporations will eventually lose their competitive edge. Corporations in the first mode will attract low P-E ratios because of the high variability of earnings, although in the long run these corporations will do better on average than the corporations in the second mode.

If the optimal strategy in stocks is “buy and hold” because trading costs are high, then it follows that the better bet is to invest in corporations in the first mode. Unfortunately, the corporate mind-set in the Philippines is more likely to be that of corporations in the second mode. Thus, as a general rule, the better choice is to avoid investment in the Philippine stock market; exceptionally, one can search for and invest in corporations that operate in the first mode.

Given the state of the libel laws in the Philippines, it is up to individual investors to make up their own minds on the management “styles” of corporations. But it should not be that hard. Management styles are “open secrets” in Manila.

It is arguable that if the capital markets were efficient, the market valuation of corporations in the second mode will suffer as investors factor in the eventual demise of these corporations. But such prognostication is difficult if not dangerous (as discussed below). The more prudent approach is perhaps simply to avoid investing in corporations in the second mode, and not to expect that such corporations will necessarily come to ruin.

The problem is that there is a scenario which allows for long-run survival of corporations in the second mode. It is when they can maintain their market shares through various ways of barring the entry of corporations in the first mode.

One way is through the nationality requirements that favor Philippine corporations.

Another is influence-buying, whereby corporations in the second mode “invest” part of their earnings in lobbying for rules that give them preferences. It is not far-fetched since for about a century such “investments” have worked out even if no one will offer direct evidence of this practice.

It seems a fair conjecture that the prevalence of corporations in the second mode helps to explain how and why the Philippine economy has fallen behind those of other countries in Asia.

But there is some hope. The tendency toward globalization and an increasing wariness on the part of foreign investors suggest a better future. It will be so if it becomes more difficult for corporations in the second mode to continue to stifle competition from corporations in the first mode.

Note: The ideas in this post were inspired by a reading of Leonard Mlodinow’s 2008 book, The Drunkard’s Walk: How Randomness Rules our Lives.

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