- Market Commentary
- By Jack Ablin
- August 7, 2018
Rise of the Megacaps
America’s largest companies are thriving. Like Apple, our nation’s first company to cross the $1 trillion market capitalization mark, today’s largest companies are enjoying outsized profit margins. Despite talk of increased regulations and government oversight, the profit margins among Amazon, Facebook and Netflix are currently situated in the ninetieth percentile of their historical range. The enveloping domination of the America’s largest companies is not a fluke; it’s a trend. A recent study by Justin Furman, a former Obama-era economic advisor, shows that the largest companies among disparate industries have garnered increased market share over the last few decades. The top 50 retailers, most notably Amazon and Walmart, have increased their share of industry revenue by nearly 12 percentage points between 1997 and 2012, according to Furman. Three-quarters of all American industries have become more concentrated since 1980.
A recent article in The New York Times quantifies the concentration of market power. The top 200 companies by earnings accounted for all the profits in the stock market in 2015, according to a study by Professors Rene Stultz of Ohio State University and Kathleen Kahle of the University of Arizona. In aggregate, the remaining 3,281 publicly-listed companies lost money. This concentration of profits shouldn’t be a surprise, considering that Apple and Google provide software for 99% of all smartphones and Facebook and Google take in 59 cents of every dollar spent on online advertising in the US, according to the Times report.
By omission or by design, public policy has enabled the biggest companies to envelop their respective industries. That’s evident in banking and technology, but it is apparent in other industries as well: almost half of all assets in America’s financial system are now controlled by just five banks; over the past decade, the six largest airlines consolidated into three; and 98 per cent of America’s wireless communications market is now controlled by four companies. The government regulations that have been enacted have tended to favor an industry’s largest players, owing to their economies of scale. Sarbanes-Oxley, or the “Public Company Accounting Reform and Investor Protection Act,” signed into law in 2002, imposed an onerous set of standards on all the management and boards of all public companies, regardless of their size. Thanks to Dodd-Frank and Basel equity capital standards, the capital commitment and paperwork associated with starting a new bank or brokerage firm is mind numbing. And though they doth protest, in fact this litany of regulations serves very effectively as an operational moat protecting our corporate behemoths from competition.
While military might is a factor, the path to global dominance is paved by trade abroad and economic strength at home. Trade dominance has become a worldwide strategic initiative. Beijing’s “Made in China 2025” policy initiative is perceived as a threat to the global power balance in the developed world. Florida Senator Marco Rubio personified that fear in a recent Fox interview in which he warned of the massive threat posed by Chinese companies operating within the US, calling China a “near-peer adversary hoping to overtake us.” Rubio’s China-specific fears likely reflect the wider view shared by other lawmakers, who are concerned that weakening our nation’s global Goliaths by breaking them up would disadvantage them, particularly if their foreign rivals remain large. Foreign governments also have an incentive to slap restrictions on non-domestic players, like the EU did recently to Facebook and Twitter. The European anti-trust regulators imposed a record $5 billion fine on Google for unfair trade practices. The $5 billion was paid out of operating cash and was barely mentioned in Google’s quarterly earnings report. Germany’s decision to forbid Yantai Taihai Group, a Chinese company, from buying Leifeld Metal Spinning, a German company, is the latest sign that governments are toughening their stance on Chinese investments into strategic and security-related industries.
America’s drive for global trade dominance carries several non-trivial economic costs, several of which we are living with today. Productivity, one of the key components of potential GDP growth, has been in secular decline: as calculated by the increase in output per hour of work, productivity has expanded at a scant 0.9% annualized rate over the last five years, according to the Bureau of Labor Statistics. The benefit of innovation is not often worth the cost to companies who dominate their industries; dominant players prefer to buy their upstart competitors rather than innovate in-house. Since becoming publicly traded, Google’s parent company Alphabet has made over 200 acquisitions, including Motorola Mobility, YouTube, Waze and Nest. Facebook has developed a strategy of swallowing up competitive threats, and has consumed Instagram, WhatsApp and Oculus.
Lackluster wage growth is another economic effluent flowing from the government’s laissez faire approach to business consolidation. Wages have expanded at an annualized rate of 2.4 per cent over the last five years, despite unemployment rates having fallen steadily during that time to reach levels not seen since April 2000. This is because dominant employers have more leverage in setting and growing compensation; employees, faced with fewer employers from which to choose, are forced to settle for the prevailing wage. The ratio of corporate profits to employee compensation is at levels consistent with the 1950s.
America’s pro-business policy, a trend that will likely continue, suggests that the country’s largest companies and their shareholders will luxuriate in the trappings of monopolistic dominance for years to come. Government actions to breakup AT&T in the 1980s and Microsoft in 2000 now seem like antiquated strategies that simply don’t apply anymore. Investors in mega-cap companies should expect to enjoy outsized profit margins and valuations. Though large-cap stocks appear relatively expensive, they could stay that way. Historically, small-cap value-oriented companies tended to outperform the broader market over long time horizons. Over the last 20 years, the Russell 2000 Index of small-cap stocks has outpaced the S&P 100 by 66 percentage points, or nearly 3 per cent annually. Over the last 10 years, however, small cap outperformance has been nil, as the last five years have been tilted in favor of large-caps. Expect mega-cap stocks to continue to outperform their smaller brethren as public policy continues to favor the largest names.