Rules of the game

All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.
Past performance is not a guide to future returns.

Rules have existed ever since social groups first strove to organise themselves. Harmonised weights and measures on the silk and spice routes, a national currency in seventh century China – these were the beginnings of regulation.

Rules help nurture order and stability. But things can get complicated quickly. Our interactions are now covered by a vast patchwork of legal restrictions, contractual obligations, self-regulations, co-regulations, certifications, accreditations, policies, standards and norms. Each can demand or forbid certain conduct, and the regulators involved have varying levels of independence from government. Regulations may also reflect differing industries, economies, societies and value systems, and often vary over geography and time.

An additional challenge is the way many of today’s businesses mutate. They straddle traditional industries and sometimes create new ones as they grow rapidly, and can launch products to billions of people in an instant.

Evolutions and revolutions

The rules we live by evolve, reflecting changes to technology, society and the economy. The economic historian Professor Carlota Perez has documented many of the paradigm shifts experienced since the Industrial Revolution – from canals to railways to steel to mass production to the current rise of information technologies – and their accompanying regulatory frameworks.

The chart illustrates the time lag between the development of a new technology (shown in black) and the introduction of related rules and regulatory institutions (shown in orange) designed to address social and economic concerns. Regulation can be slow to catch up. It took more than 70 years from the Ford Model T’s launch in 1908 for the first US state, New York, to make seatbelt use mandatory. And even now, their use is not compulsory for adults in New Hampshire.

This reflects the fact that regulatory change in the real world is far messier and less linear than the chart suggests. There are inevitable confrontations between defenders of the old regime and vanguards of the new. For example, in the space of just five years the US signed the Paris Agreement on climate change, withdrew, and then signed it again.

What makes all this even more challenging is that technological change is occurring at unprecedented speed. Since LTGG’s inception in 2004, we have witnessed the likes of Facebook, Amazon, Alibaba and Tencent reach such scale and herald such profound transformations in our lives that they are now being subjected to immense public and regulatory scrutiny.

Regulators and others also need to form opinions about things they didn’t grow up with, such as cryptocurrencies and facial recognition. These can be harder to get to grips with than supermarkets, automobiles and other more concrete entities. Whatever the regulatory response, company managers need to acquire new skills. Being long-term investors, we continually examine business leaders’ ability to adapt to the new rules of the game, or better yet to proactively and constructively contribute to the rules.

Differing perspectives

The standardisation of shipping containers in the 1950s made international trade more efficient, driving globalisation to fresh heights.

Today’s ‘containers’ are digital, and cross-border trade has accelerated again. We are more connected than ever, making it easier for companies to reach huge audiences. But one size doesn’t fit all. There are strong regional differences in attitudes and perspectives that need to be considered. These don’t solely reflect the fact different markets are at different stages of economic development, but also that their citizens hold different religious and political beliefs.

This adds further complexity. Local regulations reflect localised attitudes and can’t always be imposed by an external body in the same way the dimensions of shipping containers could be dictated in the past.

Differing attitudes...

How important is it for women to have the same rights as men?

Over the past 20 years do you feel your country has become more diverse? Do you think this is a good or bad thing?

How important is it that people can use the internet without government censorship?

Is it important that media can report the news without government censorship?

How important is it that people can say what they want?

…lead to differing regulation

How have different countries approached cryptocurrency regulations?

Into the morass

Moral panics coupled with the struggle of keeping up with innovation’s frenetic pace can lead politicians and their regulators to seek easy answers. There’s an appealing simplicity to slogans like ‘Break them up!’.

But the reality is there are no easy solutions, only trade-offs. Sacrifices must be made. Nuance is needed.

Observations and opportunities

Given all the complexity involved, it’s little wonder that regulations and bureaucracy are often perceived as costly burdens to businesses and the public. And that rules and officialdom are characterised as obstacles to efficiency and growth. Of course, mistakes and clumsy regulations occur. But the reality is nuanced.

The economist Professor Mariana Mazzucato has highlighted how states can spur on new technologies. This is not solely about top-down prescriptive practices, such as the goals described in China’s five-year plans. It’s also about the subtler opportunities created as a regulatory by-product.

For instance, Facebook has been subject to intense regulatory scrutiny. This encouraged it to amass tens of thousands of content moderators supported by sophisticated AI tools. It has also established an Oversight Board, which is intended to act as an independent body. While not without their flaws, these are industry-leading initiatives. And though costly, they may lead to new business opportunities. Perhaps Facebook will one day provide content moderation as a service to other businesses, rather as AWS provides cloud computing to its customers.

Similarly, the regulatory push to use electric vehicles could be an additional growth driver for Carvana, the online used-car marketplace. Its founder, Ernie Garcia, suggests that because EVs require less maintenance than internal combustion engine vehicles, large automakers may in the future have less incentive to expand their costly servicing networks. He recently mused that Carvana’s impressive logistics network and fixation on customer service could equip it to fill any resulting gaps in demand.

Another example: many investors spend an inordinate amount of time worrying about the costs of new Chinese regulatory measures levelled at large tech-enabled companies such as Alibaba, Pinduoduo and Meituan, among others. But provided the fundamentals of our long-term investment theses remain intact, sensible rules that strike an appropriate balance between innovation and stability can bring benefits. They may reinforce the longevity of companies that can not only adapt but also lead in a more regulated environment.

What can we take from all of this? When LTGG thinks about regulation, our approach to investing considers both materiality of impacts and alignment of interests. On the former, we carry out stock-specific analysis to distinguish which regulatory evolutions may materially affect a company – for better or worse – over the coming five to 10 years and beyond, and which changes are merely ‘noise’ to be tolerated along the way. As for alignment of interests, we look for companies that demonstrate thoughtfulness and adaptability when navigating regulatory changes. These companies are willing to learn from their mistakes, and proactively engage with regulators to take advantage of opportunities that align with the long-term goals of the societies and environments in which they operate.

Some holdings will inevitably fall foul of regulation. But others that master the rules of the game stand to generate asymmetric returns – for our clients, society and the planet.

Risk Factors

The views expressed in this article are those of the LTGG Team and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in November 2021 and has not been updated subsequently.
It represents views held at the time of writing and may not reflect current thinking.

Potential for Profit and Loss

All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.
Past performance is not a guide to future returns.

Stock Examples

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All information is sourced from Baillie Gifford & Co and is current unless otherwise stated. The images used in this article are for illustrative purposes only.

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