Conflict of interest

In our day-to-day work we come across several situations where we face severe conflict of interest. If we are in a situation faced with a conflict of interest, ethics demand that we disclose and move away from the situation that creates the conflict. However  if you are faced with a situation where there is a potential  conflict of interest that you note but cannot do anything about it that would probably not be as simple to deal with because the ability to remove the conflict of interest is not within your hands. Here is a simple list of certain conflict of interests that I have observed mostly within finance/commerce space over time and it would be interesting to see how they play out in terms of business decisions.

Credit Rating

This is the mother of all conflict of interest that I have ever observed. The credit rater is paid by the credit rated. In simple words, you take money from a company to provide a rating to the company. This conflict probably was at the heart of global financial crisis. However the model continues to operate the same way. Even now the credit rating companies are paid by credit rated companies and not by any independent agency. Well, to an extent credit rating agency can appear to  be unaffected by this conflict of interest, but I am sure down the line there would be an impact of this direct conflict of interest between the rating agency and the rated company. The best way to resolve this is to create an independent credit rating agency fully funded by government. The government can impose some sort of tax on corporate on overall basis and try to do this as an independent exercise completely devoid of any conflict of interest. A credit rating borne out of such a process can definitely be more unbiased and objective. 

Sell-side research

The brokerage industry thrives on brokerage commissions. Brokerage commissions are derived by the extent of trading by clients (investment companies or asset management companies). In order to elicit the interest to trade, brokerage companies come out with a series of research notes on companies in what is now popularly known as sell-side research. The idea is to trigger either buying interest or selling interest about the client firms so that that the commission earned can be increased.  Obviously this sort of research is not going to be independent or objective because the purpose of this research is basically to trigger trade actions and not to enable unbiased objective investment decision.  There is still no way out of this sell- side research dilemma.  Investment communities still continue to depend hugely on sell-side research even though they see this conflict of interest very clearly. Of course, certain regulators mandate publishing details like investment banking business done in the past one year, number of sell call/buy calls and history of calls along with actual performance. More often than not, these disclosures come in small print! 

Media

Media is probably one of the best examples of a conflict of interest. The most popular newspapers and magazines literally thrive on advertising revenues almost completely. Nearly 90% of their total income accrues from advertising revenues rather than subscription revenues. So obviously this poses a limit on how far you can go to be independent about client companies lest your main source of revenue will be hit. This is true for print media, television channels and digital media too. We all know that views that are being aired about these companies that are their clients can never be independent or objective since their existence depend on continuation of their advertising contracts. And curiously enough, the client list can also include political parties! 

Audit and Consulting

Auditors normally are mandated to be extremely independent and they have to provide independent view on the financial status of the company. Like credit rating agencies, auditors are being compensated by the company that is being audited which itself is a potential conflict of interest, but by virtue of their access to almost all records and status of company, they are also in a position to see what type of consulting mandates can be obtained and executed by the audit firms. Technically they may not do it under the same name but there are ways to get around this. 

Board of Directors

Board of directors can either be independent businessman in which case they would try to push their business opportunities or they could be simply also be a client or vendor for the company. It may not be done directly but there is always conflict of interest between being on the board and trying to influence the company to use the services of the businesses that they are directly or indirectly connected with. 

Financial audit

There may be cases where senior partners of an audit firm can hold some sort of a stake (direct or indirect) in the client company for which they conduct financial audit. This will be definitely be at the back of their mind when they conduct the financial audit because their financial fortunes are tied to the audit opinion and they may not be having the courage to give true opinion about the firm since they hold a stake in the firm. 

Hospitals

Major hospitals and to an extent even clinics of a decent size have their own testing laboratories. These laboratories house expensive, often imported, medical equipment whose capital costs need to be recovered at the earliest. Hence, doctors have implicit incentive to refer patients to sometimes necessary but most of the times unnecessary tests in order to recover the capital investments. I believe in many hospitals doctors have targets when it comes to recommending tests! 

In summary, conflict of interest abounds and surrounds us in everyday lives. It may be a source of intense frustration when it impacts our personal lives (like hospital example given above). In corporate situations, it may affect our performance as investment or portfolio manager where we rely on credit ratings or equity research to make investment decisions. In most of the cases, the cost of conflict of interest is not straightforward or apparent though we know it exists. It may pay well to be conscious of this while making decisions though in many cases it cannot be avoided. By no means, this list is exhaustive. Feel free to suggest other apparent conflict of interest that you have observed.

The connect between market leadership and wealth creation

Does it pay to invest in companies that enjoy high market share? How to measure the effect of market share?

In the online media communications industry, Google has a market share of 40%. Tencent Holdings has a market share of only 7%. Both have created extraordinary wealth to its shareholders. Google stock returned 20% annualized and Tencent 31% annualized during the last five years.

Wal-Mart enjoys an astonishing market share of 57%, but returned only 4% annualized in terms of its stock performance, while Costco with a market share of less than one-third that (18%) has provided 18% annualized return.

So, does it pay to invest in a market leader? 

The top 15 market leaders, in general, seem to have delivered value as measured by their stock price annualized return. Only two (Gazprom and HP) seems to have deleted value. Despite being the world’s largest extractor of natural gas and possessing the world’s largest gas transport system (158,200 milometers of gas trunk lines), Gazprom declined in value over the last 5 years. Similarly, HP headquartered in Palo Alto, California provides a variety of hardware and software products to a diverse range of customers and has significant brand pull. Nevertheless, it ended up on the losing side, on the stock price appreciation metric.

Barring the two, most of the others in the list boast of excellent performance proving the connection between market leadership and wealth creation. Notable among them are Google, Amgen, Costco, Microsoft, Intel, Starbucks, Gilead Sciences and American Express. Google derives profits mainly through Adwords (an online advertising service that places ads adjacent to search results and on blogs and other webpages). Google has moved beyond from just being a search engine, to commanding a chain of products through innovation, acquisitions and partnerships. For example, it partners with major electronics manufacturers in the production of its Nexus devices. Amgen is the world’s largest independent biotechnology firm, and its largest selling product lines are drugs related to preventing infections in patients undergoing chemotherapy (Neulasta/Nuepogen). Costco is the second largest warehouse, after Walmart, operating on a membership-only basis and has extensive reach within US, as well as other countries, such as Canada, UK, Australia, Mexico, Taiwan, South Korea, and Japan. Starbucks is the largest coffeehouse company in the world, with nearly 23,000 stores in 65 countries.

Company	Sector	Market Share	Return*
Wal-Mart Stores	Mass Merchant / North America	57.4%	3.9%
Google	Internet Media	40.7%	19.4%
Gazprom	Energy Exploration & Production / Europe	24.9%	-3.4%
Amgen	Biotech	21.0%	20.2%
Procter & Gamble	Household Products	19.6%	3.7%
Costco Wholesale	Mass Merchant / North America	17.8%	18.3%
Lenovo Group	Computer Hardware	17.1%	6.4%
Microsoft	Software	16.7%	12.6%
Hewlett-Packard	Computer Hardware	16.6%	-9.5%
Intel	Semiconductor Devices	15.8%	9.4%
Rosneft	Energy Exploration & Production / Europe	13.4%	3.6%
Starbucks	Restaurants / North America	13.2%	34.8%
Gilead Sciences	Biotech	12.8%	40.7%
American Express	Credit & Debit	12.7%	12.0%
MSCI World			9%

 *CAGR (Sept 2010-Sept2015)

And does it hurt to invest in market laggards?

It appears that there is cost to having low market share. Four out of bottom 15 in terms of market share witnessed decline in stock value over the last 5 years. (HP, China Shenhua Energy, Nippon Steel, and Sinopec). Also, 10 out of bottom 15 seem to have underperformed the MSCI world index. Low market share could also imply a crowded market and therefore the pressures of such a system could be affecting the performance. Prudential financial, AXA and Allianz asset management seems to be the exceptions to the trend, and have provided positive value growth to their investors over the last 5 years.

Company	Sector	Market Share	Return*
ConocoPhillips	Energy Exploration & Production / North America	4.3%	1.8%
Siemens	Electrical Equipment	4.2%	1.3%
Hewlett-Packard	IT Services	3.9%	-9.5%
Deere	Machinery	3.7%	1.2%
Allianz	Asset Management	3.6%	11.1%
BASF	Chemicals / Global	3.6%	8.1%
Hitachi	Electrical Equipment	3.4%	10.5%
China Shenhua Energy	Coal Mining	3.4%	-9.3%
Nippon Steel & Sumitomo Metal	Steel	3.1%	-5.3%
Prudential Financial	Life Insurance	3.0%	17.0%
PepsiCo	Food Manufacturing	3.0%	7.3%
Sinopec	Chemicals / Global	2.9%	-5.6%
AXA	Property & Casualty	2.8%	11.0%
AXA	Life Insurance	2.7%	11.0%
Coal India	Coal Mining	1.6%	0.7%
MSCI World			9%

 *CAGR (Sept 2010-Sept2015)

Market Leaders as Wealth Creators

Significant wealth creators also enjoy good market share in most cases. Notable among them are Google, Amgen, Gilead Sciences, Starbucks, Costco, Toyota, Boeing, etc. Gilead Sciences tops the wealth creator list with an impressive 40% annualized return to its shareholders during the last five years. The American biotechnology company that discovers, develops and commercializes therapeutics, concentrates primarily on antiviral drugs to treat patients infected with HIV, hepatitis B, hepatitis C, influenza and pulmonary diseases. It is followed by Starbucks, with an annualized return of 35%. The Internet media sector, which is dominated by Google, has also produced another significant wealth creator in Tencent Holdings (China), which provided an annualized return of 30% with only a 6.6% market share. The company represents the Asian face of internet boom by providing media, entertainment, internet and mobile phone value-added services, and it also undertakes online advertising services in China.

Company	Market Share	Sector	Return*
Gilead Sciences	12.8%	Biotech	40.7%
Starbucks	13.2%	Restaurants / North America	34.8%
Tencent Holdings	6.6%	Internet Media	30.7%
Nike	8.5%	Apparel, Footwear, and Accessories	25.1%
Airbus Group	11.5%	Aerospace & Defence	23.7%
Amgen	21%	Biotech	20.2%
Google	40.7%	Internet Media	19.4%
Toyota Motor	11.6%	Automobile OEM	18.4%
Costco Wholesale	17.8%	Mass Merchant / North America	18.3%
Anheuser-Busch inBov	7.9%	Beverages	17.1%
Prudential Financial	3%	Life Insurance	17%
Wells Fargo	10.3%	Banking / North America	15.4%
Marriott International	5%	Lodging	15.1%
Boeing	12.6%	Aerospace & Defence	14.5%
SJM Holdings	12.4%	Casinos	13.5%
MSCI World			9%

*CAGR (June 2010-Sept2015)

Market Leaders as Wealth Destroyers

Wealth destroyers mostly come from bricks and mortar industry spanning across sectors such as steel, coal mining, chemicals, machinery and energy. IBM and HSBC are the exceptions, with the former being a software company and the latter a banking company. Arcelor Mittal’s share price plunged the most in this study, with a negative return of 27%, followed by Guodian Technology in the renewable energy industry. Both command a market share of 6% and 5%, respectively. Arcelor Mittal is the world's largest steel producer, with an annual crude steel production of 98.1 million tons as on 2014, which is 10% of the world’s steel, and Guodian is one of the five largest power producers in China, engaged in development, investment, construction, operation and management of power plants.

Company	Market Share	Sector	Return*
ArcelorMittal	6%	Steel	-27.3%
Guodian Technology & Environment	4.9%	Renewable Energy	-26.8%
Hewlett-Packard	16.6%	Computer Hardware	-9.5%
China Shenhua Energy	3.4%	Coal Mining	-9.3%
Banco Santander	6.9%	Banking / Europe	-6.4%
Sinopec	2.9%	Chemicals / Global	-5.6%
Nippon Steel & Sumitomo Metal	3.1%	Steel	-5.3%
HSBC Holdings	6.4%	Banking / Europe	-5%
Caterpillar	5.6%	Machinery	-3.6%
Gazprom	24%	Energy Exploration & Production / Europe	-3.4%
Coal India	1.6%	Coal Mining	0.7%
Deere	3.7%	Machinery	1.2%
Siemens	4.2%	Electrical Equipment	1.3%
Halliburton	6.4%	Oil & Gas Service	1.3%
IBM	6.6%	Software	1.6%
MSCI World			9%

*CAGR (June 2010-Sept2015)

The No.2 Syndrome

Sometimes, the second largest market share holder can actually rank better in terms of wealth creation than the leader. Such trend cuts across several sectors. For eg., though Wal-Mart enjoys a dominant market share of 57% as compared to Costco, the warehouse group with the second highest market share of 17.8%, the annualized stock price performance of Costco is 21.5% compared to 5.3% for Wal-Mart. Similar things can be observed with Google Vs. Tencent, Amgen Vs. Gilead, P&G Vs. Unilever, Las Vegas Vs. SJM Holdings, Bank of America Vs. Wells Fargo, Coca-Cola Vs. Anheuser, Boeing Vs. Airbus, etc. In all these cases, the company with the second highest market share performed better than the sector leader in terms of wealth creation. There is apparently a discount for being the leader in some cases!

Company	Market Share (%)	Price Performance* (%)	Sector
Wal-Mart Stores (1)	57.4%	5.3%	Mass Merchant
Costco Wholesale (2)	17.8%	21.5%	Mass Merchant
Google (1)	40.7%	23.2%	Internet Media
Tencent Holdings (2)	6.6%	35.4%	Internet Media
Amgen (1)	21.0%	22.1%	Biotech
Gilead Sciences (2)	12.8%	43.9%	Biotech
Procter & Gamble (1)	19.6%	3.8%	Household Products
Unilever(2)	8.5%	9.3%	Household Products
Las Vegas Sands (1)	12.7%	6.0%	Casinos
SJM Holdings(2)	12.4%	14.3%	Casinos
Bank of America (1)	12.2%	4.6%	Banking / North America
Wells Fargo (2)	10.3%	16.9%	Banking / North America
Coca-Cola (1)	8.8%	7.5%	Beverages
Anheuser-Busch inBov  (2)	7.9%	18.3%	Beverages
Boeing (1)	12.6%	16.5%	Aerospace & Defence
Airbus Group (2)	11.5%	25.0%	Aerospace & Defence
Siemens (1)	4.2%	2.8%	Electrical Equipment
Hitachi (2)	3.4%	12.1%	Electrical Equipment

*CAGR (June 2010-Sept2015)

Conclusion

In trying to relate market leadership to wealth creation, we can see three categories:

Clear Winners (Best): Those that enjoy very high market share/leadership and have created excellent wealth for their shareholders (Amgen, Google, Costco, Microsoft)

Clear Losers (Worst): Those that have low market share and have created the least wealth or even destroyed wealth for their shareholders (Nestle, Siemens, Conco Philips, etc)

In-betweens (Better, Good, Hmm, Bad): Instances of high market share coupled with low wealth creation and vice-versa.

It is important to translate market leadership to wealth creation. In the absence of that association, sometimes market leadership can be more of a burden than a benefit.