Long's Law

by: Harry Long

Long's Law states that long term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry.

For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economics "Laws" should best be termed Economic "Tendencies." The rule roughly holds across a vast array of industries.

But why is this important? FCF margins directly impact the sustainability of high long term Return on Assets [ROA] rates. And longer term, sustained high ROA numbers dictate the unlevered return of a business. But the key word is "sustainable". And high FCF margins, according to Long's Law, are only sustainable longer term in industries with few substantial competitors.

Therefore, when the investment management industry from private equity to quantitative equity searches for a host of high performance metrics in potential investees, we can empirically demonstrate that the number of competitors in the industry usually determines sustained company outperformance (excluding growth statistics).

Long's Law is the ultimate reductionist statistic which is predictive of sustained company outperformance. Dozens of seemingly predictive statistical ratios really collapse causally to one number--the number of competitors in the industry. And there are the added benefits of determining if the measured outperformance is sustainable and if and when the outperformance is threatened (the entrance of meaningful new competition, etc).

But what are examples of publicly traded companies which might rank very highly under Long's Law? Here is an illustrative, but by no means complete, list below:

Major Payment Networks (Network Effect Businesses)

Visa (NYSE:V)

MasterCard (NYSE:MA)

Paypal (owned by Ebay (NASDAQ:EBAY)

Major Futures Exchanges (Network Effect Businesses)


Intercontinental Exchange (NYSE:ICE)


Major Online Auction Marketplaces (Network Effect Businesses)

Ebay (EBAY)

Mercadolibre (NASDAQ:MELI)

Major Credit Rating Agencies (De Facto Regulators)

Moodys (NYSE:MCO)

McGraw Hill Financial (MHFI)

Internet Search (Dominant Online Advertising)


Financial Database Firms

Factset (NYSE:FDS)

Morningstar (NASDAQ:MORN)

Capital IQ (owned by McGraw Hill Financial)

Thompson Reuters (NYSE:TRI)

Index Providers

S&P Indices (owned by McGraw Hill Financial)



But why do the businesses above share the strong prospect of sustained outperformance and protection from competition?

Network Effect Businesses are the only category of business in which market share reinforces the competitive advantage of the businesses themselves. For instance, most merchants accept Visa and MasterCard, because most customers use Visa and MasterCard. This same logic applies to major futures exchanges and to major online auction marketplaces. More people decide to sell their cars on Ebay, if they choose to sell online, because that's where the buyers for online cars congregate, and vice-versa.

Major Credit Rating Agencies are firms which have historically served as the de facto regulators of bond markets. For a variety of reasons too highly complex to go into in this article, this business has historically tended towards Oligopoly. Selling opinions for money, especially with few major competitors, is a fine business indeed.

Financial Database Firms run databases that are extremely expensive to create, yet relatively cheap to maintain, so they tend towards Oligopoly. High fixed costs and very low marginal costs can be a recipe for success when combined with a customer imperative for extremely high quality.

Index Providers are a bit more mysterious in terms of the empirical reasons for their sustained competitive advantages and relatively few competitors. However, it is intuitive to accept that, by their very definition, there are only a few widely followed, trusted, and accepted benchmarks to measure market performance. This may change in the future.

Internet Search is dominated by Google, because its algorithms are so advanced that users are served up highly accurate results. I cannot predict if this business will be shaken up by abrupt and discontinuous technological advances in the future.


If someone put a gun to my head and asked me which category of business would have the most sustainable competitive advantage in the future, I would have to say, far and away, network effect businesses. And within the universe of network effect businesses, companies like Visa and MasterCard are almost the only entities, other than governments, which can tax most payment transactions.

Visa's and MasterCard's competitive advantages are far stronger than those of other network effect businesses such as futures exchanges, or online auction marketplaces, because using Visa's and MasterCard's payment networks have been integrated into our everyday lives through the physical act of swiping cards.

Making the decision to trade futures or to log onto Ebay is really a specific decision that is not as common as walking into a store and swiping a card. Any company which has both a network effect and is integrated into the physical rituals of our everyday lives has a strong competitive advantage indeed. More importantly, rather than having to predict the demand for a specific product like Coca-Cola (NYSE:KO), one need only predict that a variety of goods and services will increasingly be purchased using payment networks supplied by Visa and MasterCard, which is a much higher probability bet.

And investment management, like any other form of strategic management, requires wagering on an uncertain future. Use Long's Law to skew the odds of sustained success in your favor. Long's Law will point to potential long term business quality, but it says nothing about valuation, timing, bull and bear markets, or the economic climate. I hope investors don't use it as an excuse to buy lazily, or buy a contemporary "Nifty Fifty" of sorts at dumb valuations. But Long's Law should be used as a tool to guide the shrewd investor towards companies which might qualify as long-term holdings and to weed out companies which suffer from increased competition.

Disclosure: I am long MCO, CME, ICE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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