Aunt Millie’s Allergy
Hamilton Point employs a rules-based system for identifying 30-40 high-quality companies for our Global Core stock portfolio. Generally comprising the bulk of client equity exposure, this strategy has been our equity “workhorse” in terms of quality standards for over 20 years. In this newsletter we explore just one of our maxims—“regulatory clarity”—that is currently relevant due to new and proposed internet privacy regulations.
Before delving further, let’s describe regulatory clarity in Hamilton Point’s investment context. Companies that pass our test for this metric must first be located in a developed country like the U.S. or England where the “rule of law” is enforced by a stable government.1 While we expect that every business (including ours) will be regulated, it becomes particularly challenging to evaluate implications when government oversight is genuinely in flux. When changes are being discussed in Washington, we find it near impossible to assess political risks and tend to avoid those situations.
Increased regulatory scrutiny also tends to coincide with negative consumer sentiment towards a sector as politicians seek to reign in companies deemed “evil” by their constituents. In this sense, favoring companies with regulatory clarity is an extension of Hamilton Point’s preference for owning companies whose products help those who use them – a rule that has kept us out of casinos and tobacco companies for decades.
There are several examples of Hamilton Point reacting to a regulatory environment, including when the banking system collapsed roughly 10 years ago, leading to “stress tests,” increased capital requirements and limitations on dividends. Soft drink companies facing “sugar taxes” were another case of heightened regulatory scrutiny converging with negative consumer sentiment and causing us to take a more critical view of a sector.2
Even when staying out of a sector leads to relative underperformance over some periods (it happens), we still prefer owning companies for the long term that are not being sued by their customers or sanctioned by government regulators. Institutionally speaking, that means we are willing to go “benchmark rogue” as we stay focused on preserving capital and not benchmarks. We believe long-term performance goals are more consistently achieved when we steer clear of negative risk factors that we would argue increase volatility and are nearly impossible to predict.
Have Your Zeroes Talk to My Ones
A less dramatic but potentially far reaching contemporary issue concerns the regulatory clarity surrounding internet privacy. Given our Global Core holdings in Alphabet (Google), Apple, Bookings (Priceline) and eBay2—and many companies conducting online sales or social media marketing—we diligently watch for potential regulatory changes in this area.
Hamilton Point first included Google in its portfolios because we believed in the magic of their business model and the potential power of their profitability was obvious. “Googling” meant you could search for a rake or hotel and receive instant, relevant results. However, one would later be treated (bombarded?) with ads from rake manufacturers and hoteliers as well as from lawn mower and airline companies since Google had taken the initiative to alert others as to our preferences. Few complained because the wonders of the web far exceeded any perceived cost in terms of lost privacy. Thanks Google!
As time went on, Google, Facebook and others began scanning their users’ content for information that would, sometimes unbeknownst to users, be “sold” to advertisers. This practice sounds icky to some, but was perfectly legal since the internet was lightly regulated. Even as Google and Facebook scaled back this practice in the wake of public criticism, they still allowed third-party developers to access the data.3
Although only a rough analogy, imagine if 50 years ago, the Postal Service was allowed to read our mail, gleaning content that it then sold to private industry. In exchange for cash, the Postal Service, after learning of Aunt Millie’s wool allergy, might suggest that L.L. Bean advertise cotton sweaters to her. L.L. Bean (and others) might have paid enough for this information such that stamps became free while Postal advertising revenues and profitability (imagine that!) surged.
Staying the Course
In recent years, we have grown more troubled as to when and how regulators may someday take issue with internet privacy. Historically, this state of regulatory instability is a signal to “steer clear” as discussed previously; however, internet commerce is an emerging and largely unregulated industry that is experiencing its first serious scrutiny over its operations as compared to mature sectors that are already highly regulated.
Thus far, Europe is ahead of the U.S. on this regulatory front as they passed the General Data Protection Regulation (“GDPR”) in May 2018. Its provisions explicitly protect Europeans through a right to be informed of who is collecting data and for what purpose, as well as a “Right to be Forgotten” when asking companies to delete data. It also requires companies to more proactively manage data security and to promptly notify authorities when breaches occur.4 In June 2018, California followed with the California Consumer Privacy Act (“CCPA”), which mirrored GDPR and could serve as a template for expanding state and federal regulations.
Despite some uncertainty, we believe new regulations for the internet may actually have at least two potential positive effects. First, though potentially disruptive to components of certain business models in the short-term, it does pave the way for future growth of “big tech” as consumers at least feel like they have some control over what data they provide and how it is used. Secondly, there is empirical evidence that regulation often helps large, incumbent industry players in the long run as they already have the built-in customer base as well as resources to devote to compliance with new regulations.
In summary, we are not likely to completely exit internet related companies like we did in years past with some sectors facing a lack of clarity on the regulatory front; however, we will closely monitor and be careful about adding new companies in this sector until we feel better about where the regulatory environment is heading for Aunt Millie and the rest of us.
1) Countries that fail are too long to list, but we recommend reading Red Notice by Bill Browder to comprehend the stark contrast and risks associated with investing in a country like Russia, for example.
2) For a free list of all recommendations made by Hamilton Point during the last year and the time periods discussed, please contact us.
3) MacMillan, Douglas. “Tech’s ‘Dirty Secret’: The App Developers Sifting Through Your Gmail.” Wall Street Journal. July 2, 2018.
4) “The 6 Key Elements of the GDPR.” Experian Limited. Retrieved from https://www.experian.co.uk/gdpr/six-key-elements-of-gdpr.html