Where's the competition?

The best way for capitalism to create maximum value for society – and for shareholders – is when competition works as well as possible.

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How much profit is too much?

That sounds like a funny thing for a self-confessed capitalist and investor to ask, right?

To (mis)quote Creedence Clearwater Revival:

"And when you ask 'em, "How much should we make?"
Ooh, they only answer, "More, more, more, more!""

Right?

Well, kinda.

More, sure.

But more… over the long term.

And that time frame is a distinction that matters.

This week, Commonwealth Bank of Australia (ASX: CBA), Woolworths Group Ltd (ASX: WOW) and Coles Group Ltd (ASX: COL) announced big jumps in profit.

Ampol Ltd (ASX: ALD) made a motza.

While, at the same time, hiking prices for their customers and blaming inflation.

Now, settle down you lot shouting at the back.

I completely agree that they should be free to increase prices.

And there are those who complain when companies make more money but are (not so) strangely silent when they make less.

They criticise 'profiteering', but don't offer to make up the difference when profits fall.

Frankly, this 'one way' expectation is… silly.

And, if I can say it politely, kinda exposes the critics' motivations… and misunderstanding.

My firmly held view is that a well-functioning system of democratic capitalism needs a decent profit motive.

If you know you're going to have profits garnished when you make them, but you're going to be on your own during the tough times… that doesn't exactly incentivise growth and risk-taking.

But, nor do I think companies should have an unfettered ability to raise prices.

Not (just) because it hurts those least able to afford them.

But because it signals a market in which competition is, if not broken, at least not operating as well as it should.

In theory, higher prices from one market participant should mean consumers switch to the others.

That ebb and flow of supply and demand, in a well-functioning market, will see to it that no one company (or companies) can get away with raising prices meaningfully above a level of economic viability and customer desire (more on that later).

And so…

Well, I'll let you decide.

If CBA, Ampol and our grocers can increase profits by that much, doesn't it suggest something isn't working properly?

I would say that's precisely the implication.

But here's the thing: it's not just bad for consumers.

It's bad for the whole economy, including those other companies in which we hold shares.

If prices are too high in some sectors, those companies are capturing excess profits… money that could otherwise be spent in other businesses.

Writ large, that lowers our overall standards of living and, as a result, the levels of economic activity and success we could otherwise enjoy.

It's short term gain for long term pain.

And – just ask Woolies shareholders who owned shares in the company between 2014 and 2016 – often these higher profit margins become a millstone around the neck of a business.

They get so addicted to the margins, they stop being competitive… and fixing the latter can come at a serious cost to the former, taking shareholders down with them.

In Woolies' case, the company made world–beating grocery margins… for a while.

And then it all came a cropper.

Which is, hopefully, a cautionary tale.

No, I'm not predicting – or even suggesting – that the companies I mentioned above are necessarily headed for a fall.

I'm just making the point that short term profits, if unsustainable, can actually come at the expense of longer term value creation… when competition works.

And here's the kicker – and a point I've made before: the best way for capitalism to create maximum value for society – and for shareholders – is when competition works as well as possible.

That's when scarce resources are most effectively and efficiently allocated, leading to the greatest creation of value – for all of us; consumers, shareholders… the lot.

Don't get me wrong: I love it when companies in which I own shares can flex genuine pricing power. And I can admire it even in companies I don't own. The price premium for an Apple product defies rationality (in my view, anyway!)… yet it's earned not because competition doesn't work, but because Apple has convinced many of us to pay up – big – for its products.

The same applies to many other businesses in many different categories: Tiffany, Mercedes, Coke and plenty more.

But – and here's the key difference – they do it by convincing the customer that they're worth more (whether you or I disagree with those customers' assessments is irrelevant, by the way!), not by taking advantage of short term market dislocations or because customers have no other choice.

As investors, I'd suggest that's the key question to ask: how much of the pricing power I'm seeing is genuinely ongoing, and how much is because of short-term factors.

The former is a sight to behold (and, at the right price, a joy to own). The latter might just be skating on very thin ice.

Fool on!

Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Apple. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool Australia has positions in and has recommended Coles Group. The Motley Fool Australia has recommended Apple. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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