The rise of US superstar firms: how will it impact investors?
Over the past two decades, we have seen a number of large US companies becoming more and more dominant in their industries. They’ve come to be known as “superstar” firms given how they generally overshadow their competition in terms of sales, profits and even stock market returns. Common examples include Apple, Amazon, Facebook, Microsoft and Alphabet (Google’s parent company).
While such dominance has been a boon for shareholders who have benefited from impressive profit and share price growth, it hasn’t necessarily been as beneficial for consumers and it could be contributing to worsening income inequality. We believe this will result in greater scrutiny from regulators, which could be a significant risk for investors in these blockbusting firms.
How have firms risen to superstar status?
The explosion in digital products, data and software has made it possible for firms to rapidly acquire new customers and dominate their respective market at virtually zero additional cost. Some industry leaders have also benefited from the network effects that are present on social media platforms, where the value of their service increases with the number of participants.
These effects have been particularly marked in the IT sector. For instance, Google receives 88% of all US internet search activity, Facebook controls 42% of US social media and almost all mobile operating systems are provided by either Apple (iOS) or Google (Android). The dominance of these digital platforms and products has created powerful barriers to entry for competitors.
Competition has been further weakened by the flood of mergers and acquisitions (M&A) seen in recent years in the US. M&A refers to the buying, selling or combining of companies.
As companies have become bigger, they’ve been more able to buy their competition to stop them from becoming a threat. Meanwhile, regulatory authorities seem to have become increasingly lax in their enforcement of anticompetitive behaviour.
How has this impacted investors?
As these superstars have become more powerful, they have commanded a greater share of the economic pie and of market returns. Over the past two decades, the top 20 performing stocks in the Russell 3000 Index (just 0.7% of constituents) accounted for 25% of the index’s total return. This has been highly beneficial for shareholders and for passive investors (who own all the same shares in the same proportions as an index).
How has it impacted the labour market?
While corporate profits as a share of GDP have risen from around 6-8% in the 1990s to 10-12% today, the labour market’s share has decreased in almost mirror image. It has been on the decline for about three decades, but has accelerated since the turn of the century, falling from around 64% to 57%.
Although returns from stocks have increased as industries have become more concentrated, on average low-income households derive a much smaller proportion of their wealth from stock ownership than high-income households. So, although industry concentration has boosted shareholder returns, the benefits have not been equally distributed among the US population. This is contributing to a worsening of income inequality.
What does this mean for the superstars’ future?
Growing discontent with stagnating income levels has contributed to the populist movement in the US and has resulted in calls for government intervention. Both the Department of Justice and Federal Trade Commission have launched investigations into Google, Apple, Facebook and Amazon. Elizabeth Warren, one of the US Democratic presidential candidates, has also floated the idea of breaking some of these companies up.
Increased regulation could pose significant risks to superstar firms’ revenue growth and profit margins. In the past, we have seen regulatory action against certain superstars coincide with lower share prices and sales growth. Rising regulatory scrutiny over the coming years could be a challenging development for superstars and therefore their shareholders.
We think passive US equity investors may face greater risks than their active peers because market-cap weighted portfolios are generally biased towards large-cap stocks. However, fund managers with the flexibility to discriminate between the potential winners and losers could better navigate the risks and opportunities that lie ahead.
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