The rise of US superstar firms and its implications for investors
Competition is the bedrock of the market economy. It incentivises firms to keep prices low, produce better quality products and offer attractive wages. However, over the past two decades, there have been signs that competition has weakened across the US economy.
More than 75% of US industries have become more concentrated, as a handful of “superstar” firms increasingly dominate their respective industries in terms of sales, profits and equity returns. Although this winner-takes-all market has been great for investors, there is growing concern that it is indirectly harming consumers and worsening income inequality. This brings the increased possibility of regulatory intervention, which could be damaging for investors in these blockbusting firms.
Why has this happened?
Technological innovation has significantly transformed the US competitive landscape. The proliferation of digital products and intangible inputs such as data and software have enabled tech firms to rapidly acquire new customers and dominate their respective market at virtually zero marginal cost. Some industry leaders have also benefitted 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 have created powerful barriers to entry for competitors.
Competition has been further weakened by the flood of mergers and acquisitions (M&A). Over the past three decades, the average number of US M&A deals per year increased from around 5,600 to more than 10,000. Lax antitrust enforcement has facilitated this wave of market consolidation, as regulatory authorities have challenged fewer deals on anticompetitive grounds than in the past. This has paved the way for large companies in industries such as telecoms, pharmaceuticals and airlines to consolidate their market shares.
How have investors been impacted?
Rising market power has helped US firms earn a growing a slice of the economic pie. Since the 1990s, corporate profits as a share of GDP have risen from around 6-8% to 10-12% today. This is almost a mirror image of labour’s income share, which has been on the decline for about three decades, but has accelerated since the turn of the century, falling from around 64% to 57%.
This reallocation of output towards superstar firms and away from workers has contributed towards rising income inequality. Equity returns have increased as industries have become more concentrated. But on average, low-income households derive a much smaller share 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.
As superstar firms have prospered, stock market leadership has narrowed. 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 meant that market breadth – the proportion of stocks that outperformed the index – has trended below the long-term average for a number of years.
In practice passive investors have benefited more than active from the strong market performance of superstar firms. The problem now is that with concentration levels increasing in the US stock market, passive investors are taking more risk than they realise and are therefore exposing themselves to a potential reversal of recent market trends.
What could reverse the ascent of superstars?
Growing disaffection with stagnating income levels has contributed to the populist movement in the US and has been channelled into 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 poses significant downside risks to superstar firms’ revenue growth, profit margins and valuations. In the past, regulatory action against certain superstars coincided with lower stock valuation multiples and share prices, and was followed by a downward shift in the trajectory of sales growth. So if anything, increasing regulatory scrutiny over the coming years could place downward pressure on the stocks concerned.
Aside from rising regulatory risk, it is not a one way bet that such companies will dominate forever either. Today’s dominant firms could be tomorrow’s Nokia or Blackberry. Passive investors are most exposed to this risk materialising. But rigorous analysis of individual companies and their prospects can help investors to manage the dangers that may lie ahead.
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