capital

What really makes capitalism work

What really makes capitalism work

 In his excellent article, ‘Only consumers can make capitalism work’ (Market Leader, June 2012), Hugh Davidson raised a number of interesting points in relation to the future of capitalism following the financial crisis. I remain strongly of the opinion that capitalism is not perfect but that recent history shows that it is the only viable system.

However, I do not believe that consumers are the only ones who make capitalism work. Capitalism only truly prospers in a democracy and in an environment where there are free markets. The emergence of China as a major economic power, while still under the rule of the Communist Party, seems to challenge this assertion.

However, China has achieved this position by being prepared to take on the role of the world’s lowest-cost manufacturer without regard to the environmental impact or the rights of its people to fair wages and other basic employment rights. In the West, we have been prepared to turn a blind eye to the impact that China’s high levels of economic activity have had on the quality of life of its people because we have been keen to benefit from the country’s low-cost goods. Meanwhile, manufacturing jobs have evaporated in the West to be replaced with jobs in services, leading to imbalances in some economies that were only highlighted when the financial services industry hit the buffers. Interestingly, the high cost of fuel, rising labour costs in China and concerns about quality have resulted in some repatriation of manufacturing from China to the US and the UK over the past couple of years.

NOT ALL PARTNERSHIPS ADD VALUE

Hugh argues that companies could be labelled ‘value extractors’ and ‘value adders’. He cites Colgate-Palmolive, John Lewis, FedEx and Google as ‘value adders’, with the banks being described as ‘value extractors’. John Lewis is often picked out as a company that has admirable values because it is a partnership. It is significant that all our major law, accountancy and stockbroking firms, as well as the old merchant banks, were originally partnerships – and some still are. Goldman Sachs was a partnership until it decided to float its shares on the New York stock exchange in 1999.

The fact that these businesses were owned by their employees did not result in them being held in the same degree of esteem as John Lewis. Even when there was less animosity towards financial firms, the fact that the employees earned a great deal of money relative to the average employee in the UK or US meant that they were not regarded as good corporate role models.

CONSUMERS HAVE CHOICES

Although it is an interesting distinction that Hugh tries to draw, I would add some qualifications to the concept of ‘value extractors’ and ‘value adders’. All companies are in business to make a profit and, if they do not achieve this, they go bust and have to be closed down with the result that jobs are lost and shareholders lose their money.

Hugh argues that companies need to be dynamic to achieve long-term success and this is absolutely true. A company that is a ‘value extractor’ under Hugh’s definition will not achieve long-term success because consumers have choices in all markets and will move away from companies that they believe are only extracting value from them. Even in the banking sector there are new entrants, such as Metro Bank, that claim to offer a better service. However, inertia seems to prevent customers from moving wholesale to new banks because of the perceived hassle of doing so. They cannot say, however, that the option is not there. I agree with Hugh that the role of marketing is crucial to the long-term success of a company. However, if the product or service that is being sold does not live up to the marketing hype, the company will not ultimately succeed. A good product or service marketed in the right way will lead to success. In this context, the consumer is the final arbiter.

SHAREHOLDERS ARE NOT PASSIVE

I managed pension funds and unit trusts in the City of London for 26 years. The firms I was responsible for often held the largest shareholdings in some of the UK’s leading companies.

On one occasion, I took the decision to call a poll at an Extraordinary General Meeting in an attempt to block the takeover of a relatively small retail company by a major retailer. The company could only be described as having a ragbag of businesses and I could not see the strategic sense in the deal. I tried to persuade other shareholders to vote against and two followed my lead, but we were still a long way short of the votes that we needed to block the deal. Needless to say, the purchase of the company turned out to be a huge waste of shareholders’ money. I realised that the best way of registering disapproval of a strategy was to sell the shares and I never tried to call a poll again. By selling the shares,you push down the share price and this sends a strong message to the management. If the shares go down far enough, the board is likely to question the management’s strategy and this often brings about management change.

Thus, it is not the case that just because shareholders do not make big public stands, they are not influencing what happens to a company. Hugh suggests that the major shareholders are totally passive and have little contact with companies. This is not the case. Institutional shareholders have regular meetings with company management, which give them the opportunity to put across their point of view and express dissatisfaction if they wish. It is true that the number of individual shareholders in companies is now very low, but one must remember that the pension funds and insurance companies that own shares in companies are acting on our behalf.

We all have some form of insurance and most of us have some pension provision. This money is managed by professional fund managers, who have our best interests at heart. Hugh suggests in his article that fund managers take a short-term outlook, but this is driven by trustees, unitholders and policyholders. If you buy an ISA, you want to see the value of it grow year by year. You want your fund manager to do well. The fund manager is aware that if he does not do well, you will sell your holding in his unit trust and buy another one managed by someone else. Again, marketing has a big role to play in the fund management industry. Those firms that manage unit trusts spend considerable sums of money marketing their products with the focus being on the first quarter of the year, which is viewed as the ‘ISA season’. If clever marketing is not matched by good customer service and sound performance, the company will not achieve long-term success.

SERVICE FIRMS ARE DIFFERENT

Returning to the general concept of ‘value extractors’ and ‘value adders’, I agree that in a capitalist society, only value adders will succeed and all companies must aim to add value to retain their customers over the long term.

However, it is harder for professional firms to achieve this as there is a high degree of reliance on personal relationships. When a fund manager moves from one firm to another, customers will follow. When an executive moves from Procter & Gamble to Unilever, this will not result in customers changing from Ariel to Persil. Thus, with a good product and strong marketing, brand-based companies have an excellent chance of establishing a presence in markets that will endure.

ONLY INDIVIDUALS CAN MAKE CAPITALISM WORK

My conclusion is that individuals, rather than consumers, make capitalism work. As voters, they elect governments. As employees, they have the ability to make their businesses prosper through innovation and hard work. As consumers, they have the power to determine a company’s future. As shareholders through their pension funds, insurance policies and savings, they have fund managers working for them who can determine whether a company’s shares go up or down, with the attendant consequences. It is the individual who is key to the success of capitalism, and that is something that we truly understand in Britain. [email protected]

 HUGH DAVIDSON COMMENTS...

Nicola Horlick’s interesting and constructive response raises important points. Her strong commitment to customer value is apparent and refreshing. I agree that consumers are not the only people who can make capitalism work, and my article acknowledges this. However, they seem by far the most important group. Improved education and the internet will enable them to leverage their immense purchasing power more effectively in future. Nicola raises the important question of whether it is true that in a capitalist society, only value adders will succeed. I wish this were true but fear that, at present, it isn’t. Nicola says ‘value extractors’ will not achieve long-term success, as consumers have choices in all markets and will move away.

However, in many market sectors, including banking and energy, this admirable philosophy does not appear to work, because there may be only limited choice. For example, three of the four major UK banks, which dominate the UK retail market, provide lamentable interest rates on instant access accounts. They sometimes disadvantage existing customers by giving better rates to new customers. Credit card operators are no better: average interest rates have risen from 16.5% to 18.8% since 2007 (source: Moneyfacts), despite a decline in bank rate from 5.5% to 0.5% over this period.

Unfortunately, in many business sectors, ‘value extraction’ and its undesirable practices remain highly profitable. As Nicola observes, inertia is also a factor. How far should customers be blamed for this? Most people are incredibly busy. Is it reasonable to expect them to devote large amounts of time to being effective customers – struggling to detect hidden charges, understanding opaque pricing and deciphering the small print in tricky contracts? What is the proper role of shareholders? I defer to Nicola’s superior knowledge of financial services but suspect that most unit trust and pension fund managers (‘shareholders’) make little effort to understand the views of the millions of people whose interests they purport to represent. Why do they not conduct regular market research to discover what their real customers think and want? Do these customers have a long-term perspective, like Warren Buffett, or are they short-term profit maximisers, as Nicola suggests?

Do they want fund managers to confront the boards of erring companies on matters of principle, such as CEO remuneration, or would they prefer them to sell their shares when quiet advice has been ignored? In 40 years of investing in unit trusts, I have never once been asked for my views, yet good online or phone surveys are relatively cheap. It should be a high priority for governments, regulators, marketers and customers to make ‘value extraction’ unprofitable. So how can this best be done? Nicola has initiated a valuable debate. It would be interesting to hear the views of others.

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