Regulatory risk awareness

September 28, 2023

Norwegian fish farm for salmon growing in natural environment.

Regulatory risk is nothing new to investors, but it has gained prominence in the current geopolitical climate. Companies globally, especially those with operations or manufacturing facilities in China, are  closely monitoring actions their government might take to undermine diplomatic relations. In the banking sector, the situation with SVB has led analysts to expect stricter regulatory frameworks for regional banks. Additionally, the ongoing Hollywood strikes have spotlighted AI as a contentious issue; actors are advocating for regulations that restrict studios from using their likeness for AI-generated content. And the list goes on.

In the 1990s and early 2000s, a laissez-faire attitude prevailed in developed countries, particularly in the US. It was the proof that the capitalist business model was sustainable, a perception supported by the slow pace of regulation during the quickly developing dotcom bubble and the pre-financial crisis housing market. In a hegemonic global environment, smaller nations found few reasons not to strategically align themselves with dominant powers, leading to accelerated deregulation in many developed countries. However, this framework began to shift as the US-led global world order faced challenges from competing political and economic ideologies.

As the US initiated a trade war with China and raised tariffs on various goods, many allied nations started reassessing their global trade strategies to safeguard their own economic interests. We believe the growing rift between the US and China will eventually force every government to choose sides and evaluate their dependencies on either power. Germany, for example, is reconsidering its longstanding industrial relationship with China and taking steps to reduce that reliance.

Enter the cycle of protectionism. The consequences of protectionism are well-documented: higher prices due to lack of competition, which leads to persistent inflation; weaker economic growth since international trade isn’t fully offset by domestic consumption, and a more fragile labour market as a result. When various stakeholders voice their discontent with a worsening economic environment, democratic governments often respond by enacting policies, introducing regulations or applying other short-term solutions in an attempt to alleviate the problems they created. These often penalize high-performing industries or companies and may involve levying taxes or setting price ceilings. Such changes catch both company management and shareholders off-guard.

Our clients know that Global Alpha uses a bottom-up approach to stock picking. However, our team also recognizes the increasing need in being risk aware about changes in regulatory frameworks, both at the industry and company levels.

A striking example occurred around this time last year with one of our holdings, Norway Royal Salmon (NRS). The Norwegian government unexpectedly announced a 40% tax rate on resources, which included salmon. Although the company had a solid business model and shareholder satisfaction was high, the stock dropped over 20% in a day, making it one of our worst performers for that quarter. Nevertheless, it was widely understood that NRS was set to merge with one of its competitors, Salmar. We believed this merger would provide for shareholders as it would create one of the largest players worldwide in fish farming and significant advantages, especially given that the larger entity could more effectively adapt to this new tax than smaller competitors. As of March 2023, the Norwegian government lowered its proposed tax rate to 35% to facilitate legislative approval, and we remain happy shareholders of Salmar.

Another recent case involves CVS Group (CVSG LN), a UK-based integrated provider of veterinary care. In early September, the UK Competition and Markets Authority (CMA) announced its review of competitiveness in the veterinary sector, causing CVSG stock to drop more than 25%. Investors immediately assumed that CVS, as the largest player in the space, would be the review’s primary focus. However, our analysis suggests these concerns may be exaggerated. Reviews by the CMA do not always lead to material industry impacts, as shown by its review of UK grocers earlier this year. Furthermore, while CVS has been a major player in consolidating the UK veterinary industry, it has not led to unreasonable price hikes. Average increases for CVS products and services hover around 3% net, which is unlikely to be seen as an outlier. There are minor areas, like lack of transparency in cross-selling and customer awareness regarding chain ownership, where CVS might face some hurdles, but we do not anticipate a substantial impact on the business model.

Lastly, it is worth noting that regulatory and policy shifts can provide positive effects. The waste management industry is expected to benefit as recycling becomes increasingly crucial in creating more sustainable societies. Our portfolios include waste management companies like Casella Waste (CWST US) and Renewi (RWI LN). We expect that new recycling requirements across various commodities will improve margins in what has historically been a low-margin industry.

While no one on Global Alpha’s investment team is a policy expert, our job requires us to consider two important angles: the potential threats to a business model arising from policy shifts, and the actual impact on our investment thesis when a regulatory change happens. One reason for our cautious stance on AI investment opportunities is the level of uncertainty regarding when and how governments will implement regulations. Salmon farming and veterinary care may not capture the public imagination like AI does, but we are confident in our ability to navigate regulatory risks in these industries more successfully.

Global Alpha Capital Management Ltd.
September 28th, 2023