Rules Favor the Big Players

I follow economists the way some folks follow football players...

And George Stigler – winner of the 1982 Nobel prize in economics – would be near the top of my fantasy draft.

Stigler is a key leader of the Chicago school of thought, which promotes the value of the free market with limited government intervention. And one of his favorite concepts is what's called "regulatory capture."

In short, that's when regulatory agencies are influenced or controlled by the industries they're supposed to regulate.

Regulatory agencies are vulnerable to capture because the bureaucrats running those agencies want to keep their jobs. Big companies have more information, resources, and organization than consumer groups. It gives them an advantage in influencing regulatory decisions.

And this outsized influence, in turn, gives them a leg up on the competition.

By pressuring the government, big corporations can push for regulations that make it harder for competition to survive... or even get off the ground. Plus, they can take a bigger slice of the government budgetary pie.

As I'll explain today, regulatory capture isn't a black-and-white issue. While it offers benefits like stability to investors, it can also stifle innovation and growth.

Consider defense stocks, which are on a lot of investors' minds lately...

Specifically, I want to talk about the military-industrial complex.

Most folks realize the aerospace and defense (A&D) industry is dominated by a handful of players. These companies have a heavy influence on U.S. defense policy. And the bulk of our military budget goes to straight to their coffers.

The U.S. has one of the largest militaries in the world... and plenty of enemies. Our government needs military equipment. It can't afford to blow off its top suppliers.

So A&D giants like Lockheed Martin (LMT) reap the benefits of regulatory capture. They can pressure the government to restrict market entry... and protect (or even increase) prices because there's such little competition.

Lockheed is one of the top companies in the A&D sector, which means it has plenty of lobbying power. It was a heavy supporter of the National Defense Authorization Act for Fiscal Year 2018 ("FY18 NDAA").

In its most basic sense, the NDAA determines the military budget for the upcoming fiscal year. And FY18 NDAA was the highest military budget since 2011... which translated to a big spike in Lockheed's Uniform earnings that year.

Take a look...

As you can see, Lockheed's earnings spiked from 2017 to 2018. The U.S. isn't looking to funnel money into new companies. It has its list of go-to vendors who keep delivering exactly what the government wants.

In many cases, this is because the same people are involved. Many top executives at defense companies used to serve in the military or held positions within the government.

This relationship is an immense help for cash flows.

That being said, regulatory capture comes with a trade-off...

While it could bring in high returns, it also reduces innovation. New businesses can't enter the market, while incumbents have no incentive to take risks.

Subscribers to our Altimetry's Hidden Alpha advisory know that we've been holding Lockheed for more than a year... and we're still bullish on the stock. It's in a great spot as the world spends more money on defense than ever before.

That being said, innovation is essential for growth. So if you're looking for hundreds-of-percent gains, you have to find industries that aren't being regulated to death.

Today, technology – and specifically artificial intelligence – is a good place to start. This market is still relatively new and these companies are constantly innovating.

It's also not as heavily regulated as other industries, which makes it less susceptible to regulatory capture.

In short, if you want to book the biggest upside... the most innovative industries will lead the way.

Wishing you love, joy, and peace,

Joel
October 13, 2023