Investing during regulatory headwinds

There are few investments more profitable than unregulated monopolies. If there was ever a clue to the previous statement it should be Google's threat to leave Australia as they fight one of their battles on the inevitable onslaught of global regulation.

The threat to leave is an interesting one – it’s akin to them proclaiming we can’t cope without them, that they are both necessary and irreplaceable – read here a monopoly.

Even forgetting the fact that most users use the Google Search bar as a location to type their desired URL, a 95 per cent share of search in Australia is as dominant as any unregulated business has ever been.

Think of it this way, any other business with a modicum of competition would simply fight regulation and hope for the best. If anything, the arrogance of Google will only remind local legislators how important pushing back against their power is. And to my surprise, our Government looks as though it will hold its ground.

But the question technology sector investors should be asking themselves is this; will Alphabet and other big tech firms remain a good investment in the short term?

Well, like all investments, it depends. Let’s explore.

Google, won’t remove its search engine from the Australian marketplace – there, I said it.

In economic periods like this – one where Governments are about to get serious about regulation, income inequality and re-stablishing the institutions that modern mixed economy capitalism was built on – behavioural economics and game theory are far more important than sentiment and fundamental analysis.

While I don’t think the legislation to protect Australia’s news sector is the ideal solution, it seems likely it will go through though. And when it does, Alphabet won’t pull their search.

Of course, the rhetoric around it is to send a message to bigger markets than Australia, but if they did – it would be a fool’s errand.

Here’s why: The Australian economy and local internet users will not skip a beat.

Many would revert to Microsoft’s Bing search engine and be pleasantly surprised at its efficacy. Others would use Duck Duck Go – the privacy-focused engine, others would use links from the social web. The vast majority, however, would be a tiny bit less lazy and actually type in the internet address of their preferred news sites in the URL bar.

The best bit is that the alternatives would get better every day that more people use them. The power of Google’s search is that the AI engine learns with every interaction – and so too would its competitors.

A bigger threat would be to remove the entire suite of Alphabet products which includes the Android operating system, Google maps, Chrome, Youtube, and Gmail to name a few.

Again, most would remain accessible via VPN services while also giving a chance to the substitutes – many of which are ironically owned by other big tech firms, some also facing anti-trust scrutiny. Pointing to the fact that such actions are long overdue.

The test case in Australia will provide a clear playbook to other countries moving towards regulating big tech. What all of them will quickly realise is that while Google has built a successful economic monopoly, it is also highly substitutable.

The net result of Google's leadership claiming foul and threatening to pull search is that Alphabet has painted themselves into a corner. They have demonstrated the only reason they are so powerful is that Governments globally have either not bothered to or not understood the need for tech sector regulation. Please note: this is coming from a raving capitalist.

And now, Alphabet faces a classic prisoners dilemma. They are in a lose-lose situation:

• If they remove their search engine in Australia – our economy won’t skip a beat and other Governments also considering legislation will see that, and act accordingly.
• If they keep their search engine operational in Australia and bear the new costs of regulation in the news sector, other countries will also proceed with local forms of legislation.

Governments are starting to remember that they are sovereign, and not all forms of globalisation benefit their local economy. What’s worse, is that either way, their emerging competitors in search (potentially Apple included who now have effective image and voice search engines operating effectively within the iOS ecosystem) will gain a serious leg up.

A more shrewd strategy from Alphabet would’ve been to see the tide shifting against big tech (who are no longer seen as idolised innovators) and pre-emptively protect their current monopoly position through assisting the news ecosystem in some manner. Or even to relinquish market share on purpose. Maintaining power is so very often a function of sharing more than the natural market demands.

So, when we look at the wider gamut of big tech we see a simple pattern – we can’t live without the services they provide – but we could in fact replace the companies that currently provide them.

All of them, it turns out, are only as powerful because of their sheer size. Their more recent economic fortune is proportional to the number of people using their platform – and the barriers to exit. The more users a platform has, the more functional it becomes, making switching costs high. But once this pattern is reversed we will see a dramatic technology power shift.

Historically, there have been antitrust cases where the fragmented aggregate corporate market capitlisation post-bust-up, was higher than the monopolist who got busted up. AT&T springs to mind. But as investors, our goal should be about leveraging reasonably predictable earnings and earnings growth – when we do that, the share price looks after itself in the long run.

And so, investing in times of burgeoning regulation on the tech sector, it seems wise to invest carefully in any stocks under investigation.

The good news is that not all big tech is in the headlights. Microsoft, who faced their own antitrust investigation in 1999, could in fact be a major beneficiary of actions against others, as could Apple.

A smart tech portfolio play may well be to create a substitute portfolio or simply to invest in the wider sector (a quasi index strategy) as an admission that no one really knows how the regulation will pan out across different legislative geographies.

In the short run, the geopolitical performance of corporate leadership and understanding of game theory will be more important than product innovation.

It’s always the case as new sectors emerge to be dominant. But one thing we do know for sure is that the entire world is digitising and the sector will likely outperform the wider market despite tech's current lofty valuations.