DOUBLE AGENTS (JUNE 2004)

Conflicts of interest in the business world sometimes play to an investor’s advantage

In a recent lecture given at the University of California, Charles T. Munger described a test he had performed at a number of US business schools.5 _This

test involved the Berkshire Hathaway vice-chairman asking the MBA stu- dents the following question: “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” The business school students all nod in agreement. Munger then goes on: “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” Some students come up with the luxury good para- dox, whereby higher prices indicate superior quality which, in turn, leads to greater sales.

Very few students identify Munger’s answer, namely that when the cus- tomer is not involved directly in the purchasing decision, then higher prices can be used to bribe the purchaser’s agent and can result in both higher profit margins and sales volumes. From an economist’s perspective, the customer experiences an agency problem. Agency creates the potential for supernor- mal profits for both agents and producers. Investors who understand the process can profit, too. It’s worth examining how the agency issue – hitherto something discussed mainly in relation to the dysfunctionality of the invest- ment management industry – relates to a number of companies we own or may purchase at some stage in the future (price permitting, that is).

Normal relations between provider, intermediary and consumer are distorted when the consumer lacks understanding and relies on a suppos- edly independent intermediary. In many cases the relationship between the intermediary and the product provider has developed to the point where these parties form a tacit alliance to exploit consumer ignorance. We came across this phenomenon with Geberit, the Swiss sanitary systems manufac- turer. The company sells its product to plumbers via wholesalers who then install them in the end-customer’s home or commercial building. Geberit has a push-pull marketing strategy whereby plumbers are educated to “pull” the product through the wholesale channel, and company sales representa- tives “push” the product to wholesalers. When we asked senior manage- ment about pricing pressure, we were told that plumbers welcomed price

increases, since they were paid on a percentage commission basis for the system installation.

This model encourages innovation – in Geberit’s case, it might be a new pre-wall installation system (don’t ask) – as the plumber-agent finds it easier to persuade customers to pay up for novelty. This had led to frantic product development at Geberit, where around a third of the company’s sales derive from products introduced over the last three years. The somewhat unholy alliance between Geberit and plumbers has produced a deep profit pool, from which Geberit takes a healthy share (it enjoys margins of over 15 per cent at the group operating profit level). The company’s high market share – around 50 per cent in its seven core European markets – and the fragmenta- tion of the plumbing industry help to maintain profitability.

Of course, the company would argue that these arrangements ultimately benefit customers, as profits finance new product development. That’s as may be. What’s clear is that Geberit has an extremely effective business model, with 8 per cent annual growth at the top line level over two decades.

An unholy alliance between producers and distributors exploiting cus- tomer ignorance is also prevalent in the healthcare sector. Without going into the dubious marketing ethics of the pharmaceutical industry, we have found agency models similar to Geberit’s among European dental implant and hearing aid manufacturers. Nobel Biocare and Straumann are Swiss leaders in the field of dental implant technology. Constant innovation and customer (in this case, the dentist) education has driven strong growth and high margins. Nobel Biocare has grown revenues at 17 per cent p.a. since 1995, and its latest operating profit margin was 24 per cent. Dentists who adopt its implant technique, which replaces the traditional crown and bridge solution, earn higher revenues. Customers end up with better teeth, and shareholders are smiling!

In the upscale hearing aid market, a field dominated by European firms – Siemens, William Demant, GN Store Nord, and Phonak – there is a similar emphasis on continuous innovation. The fitters of hearing aids, like den- tists, are keen to sell high-end products which earn them more money. We understand from William Demant (a portfolio holding with margins above 20 per cent after spending around 7 per cent of sales on R&D) that one of the defining characteristics of the high-end products is that they require a customized fitting, since everyone’s “ocular canal” is unique. Their hearing aids cost around $1,000; on top of this, the fitter charges another $2,000 for customized service. As with Geberit’s plumbing business, innovation in hearing aid technology has been a boon for raising product prices. Once again, the customer (the fitter-agent) is not price-sensitive. The producers of

hearing aids and dental implants are helped by the fact that the markets into which they sell their products are so fragmented.

Another example of the agency model is when the paying customer doesn’t actually choose the service. Labtest is the Hong Kong subsidiary of Intertek, a company listed on the London Stock Exchange. The company’s role is to serve as a gatekeeper between Chinese consumer goods manu- facturers and American retailers. We understand that the US firms select Labtest to check the prototypes of new Chinese products to ensure that they meet the appropriate specifications. Intertek charges the Chinese firms, rather than the US retailers, for this service, a fee that constitutes a relatively low proportion of the product price (less than 1 per cent of the manufac- turer’s cost). This distancing of payer from the service selector lies at the heart of Labtest’s remarkable profitability – with margins around 33 per cent – alongside more obvious network and scale effects.

Munger is right. Customers will often pay more when agents are involved. In each of the cases we’ve discussed, the business models – whether in plumbing, dentistry, hearing aids, or product testing – involved value being transferred from the person who pays to the agent, with the producer taking a large slice of the pie. Each of these models has evolved over time and appears reasonably robust, even as consumers become better informed in the Internet age. Just as agency problems in the fund management industry have shown remarkable persistence, we expect the superior profitability of companies that exploit agency to endure.6