AIQ - The risk edition

Size matters

Will COVID-19 lead to a concentration of corporate power?

The fallout from the coronavirus pandemic could see large firms cement their dominance over weaker rivals. We examine the implications for investors.

In 1904, investigative journalist Ida Tarbell published The History of the Standard Oil Company, which documented the rise of the US oil giant under its founder, John D. Rockefeller. Exhaustively researched and vividly detailed, Tarbell’s book showed how the company wielded its monopoly power to crush smaller rivals.

Tarbell was seen as a troublemaker in some quarters – President Theodore Roosevelt dubbed her style of reform-minded journalism “muckraking”– but her book became a bestseller and played a role in turning public opinion against corporate behemoths, which were accused of stifling competition. Standard Oil was broken up by regulators in 1911.

Tarbell might have recognised the structure of US business more than a century later. Even before the coronavirus pandemic hit, bigger companies had seized market share from smaller ones, especially in the technology sector, where digital platforms favour incumbents and first movers. On a range of metrics, markets in advanced economies have become less competitive over the last two decades, most notably in the US.

COVID-19 could see dominant firms gain a further advantage, as they should be better positioned to withstand an economic downturn. So how could these trends reshape the investment landscape? And could public sentiment again turn against the largest companies, as it did in Tarbell’s day?

Zombie apocalypse

Start with the immediate consequences of the pandemic. History suggests the economic slowdown will widen existing divisions between companies. In the last three recessions, the share prices of US firms in the top quartile across ten sectors rose by an average of six per cent; those in the bottom quartile fell by 44 per cent.1

History suggests the economic slowdown will widen existing divisions between companies

A similar divergence in performance was evident in the early stages of the COVID-19 crisis. In the year to May 1, the weighted average total stock return for the top one per cent of global firms by revenue – those that made over $52 billion in 2019 – was minus nine per cent. For firms in the $200-500 million revenue bracket, the return was minus 40 per cent.2

“Some companies will be acquired, and some weaker players won’t survive bankruptcy. Consequently, capacity will either decline or simply be concentrated among fewer firms,” says Giles Parkinson, global equities fund manager at Aviva Investors. “In part, this is what recessions do – they are the impetus that finally puts ‘zombie’ firms out of their misery.”

Due to COVID-19 containment measures, the worst damage is being inflicted on companies in travel, leisure and retail, as planes are grounded, borders closed, and shops shuttered. Weak companies in these sectors had been sustained by low interest rates and easy access to capital in recent years. A 2019 KMPG report found almost 12 per cent of UK companies in travel and leisure could be categorised as zombie firms – a higher proportion than any other sector. KPMG defines zombies as those companies with static or falling turnover, low profitability, squeezed margins, limited cash reserves and high leverage, leaving them with little scope to invest in new products or equipment.3

“Leverage has gone up in recent years, as companies expected ‘lower-for-longer’ interest rates to continue,” says Colin Purdie, chief investment officer for credit at Aviva Investors. “More-indebted companies and those without fortress-like balance sheets could struggle as cash flows dwindle during the COVID-19 lockdown, especially if the market freezes up and they lose access to capital.”

Take the energy sector, which has been hit by the combined impact of the coronavirus-related demand shock and the glut of new supply from Saudi Arabia that entered the market in early March (although a new deal agreed by the OPEC cartel, Russia and the G20 to cut supplies, announced on April 12, helped stabilise prices).

Some independent oil producers in the US, many of which are highly leveraged, look particularly fragile and could face a wave of defaults and downgrades, says Purdie. Analysis from JP Morgan suggests cumulative high yield energy default rates could reach 24 per cent over the next 12 months, even if the price of crude rises in the second half of the year.4 Oil majors such as ExxonMobil, Shell and BP are in a stronger position; having retained access to debt markets, they have built formidable cash war chests to manage the COVID-19 fallout.5

Lockdown conditions would seem to favour tech giants

Elsewhere, lockdown conditions would seem to favour tech giants, already among the world’s most profitable companies. More people are shopping online, boosting Amazon’s e-commerce business, while the rise in online gaming will benefit its unit Twitch, the dominant player in the e-sports spectatorship market.

Similarly, Apple and Netflix are benefiting from greater demand for streaming services. And companies in telecoms, data infrastructure and remote-working technology should be well positioned as workforces decamp from office desks to kitchen tables.

Winners and losers

In The Myth of Capitalism: Monopolies and the death of competition, co-authored with Jonathan Tepper, Denise Hearn documented the rising concentration of industries across the US. She believes COVID-19 is likely to accelerate the trends identified in the book.

Those in the anti-monopoly space are very concerned about [the crisis] providing a competitive advantage for existing incumbents

“Those in the anti-monopoly space are very concerned about [the crisis] providing a competitive advantage for existing incumbents,” she says. “Firms like Amazon are hiring 100,000 workers, while nearly ten per cent of the American workforce files for unemployment. Challenger businesses – or even peripheral ones – that will be hampered by COVID-19 will make for attractive acquisition targets on the cheap, and the tech firms in particular are sitting on substantial cash reserves.”

As of the end of the first quarter, the big five tech firms (Alphabet, Amazon, Apple, Facebook and Microsoft) held around $560 billion in cash and marketable securities, according to public filings. And they are starting to put that cash to work: 2020 has seen the fastest rate of deal-making since 2015. In May, Facebook paid $400 million to acquire Giphy, a search engine for animated GIFs, while Amazon is set to buy autonomous vehicle start-up Zoox for a sum in excess of $1 billion.6

The crisis could lead to further concentration in other industries, too. Take airlines. At 40 of the largest US airports, a single airline already controls a majority of the market, and most big airlines have their own “fortress hubs”, airports where they face little or no competition.7 As passenger numbers drop, these larger airlines are poised to grab yet more market share from smaller rivals.

“Airlines have suffered from a sharp drop in demand. As in other industries, it’s fairly likely the bigger companies with better balance sheets and access to capital are the ones that are going to survive,” says Purdie.

“We will still need airlines after this, but probably not as much; the rise in remote working is likely to lead to less travel for work, for example. The airlines that survive this period could emerge stronger and with a greater market share. They are also likely to benefit from lower oil prices on the other side of the crisis,” he adds.

The death of competition

To an extent, what we are seeing now is capitalism doing what capitalism does – separating the wheat from the chaff, rewarding productive businesses and letting others fall away. But there is a risk COVID-19 could make markets and economies less dynamic if it accelerates the rise to dominance of the largest firms.

Data indicates US markets have steadily become more concentrated over the last two decades. The number of listed companies halved between 1997 and 2013, and the number of new listings has fallen (see Figure 1). Profits are increasingly hoarded by the leading firms among those that remain: ten per cent of public companies are responsible for 80 per cent of total profits globally, according to McKinsey research.8

Figure 1: Share of new US listed firms as percentage of total
Share of new US listed firms as percentage of total
Source: Census Bureau Business Dynamics Statistics (new firms defined as those less than one year old), 2017

The Chicago school of economics, which was influential in designing modern anti-trust law, argued monopolistic power structures rarely last because high profits attract competitors. But this no longer appears to be the case. As the academic Thomas Philippon observes in his 2019 book The Great Reversal, US industries with high profits attracted more new entrants until about 2000; since then, entrants to profitable industries have fallen as the leaders pulled away.9

Various explanations have been offered for these trends. One is the changing composition of the economy. Tech firms have grown quickly through network effects, creating digital platforms that improve the more people use them, leaving rivals unable to compete. As other sectors integrate digital technologies, network effects are spreading across economies.

Companies are increasingly investing in intangible assets such as intellectual property, design and branding, which are hugely scalable and conducive to higher output. As research from economists Jonathan Haskel and Stian Westlake shows, this may lead to greater inequality between companies, as large firms are better able to take advantage of synergies between intangibles while protecting their intellectual property. If smaller firms cannot bridge the gap, they tend to cut investment in new ideas and processes, and fall further behind.10

Large firms are increasingly using their political influence to outmuscle rivals

Large firms are also increasingly using their political influence to outmuscle rivals. Philippon documents how US corporate giants are squashing competition by lobbying governments and spending lavishly on political campaign contributions to ensure anti-trust enforcement remains weak. This may be one reason why the so-called “buy-and-kill” tactics deployed by big firms against smaller rivals with promising ideas – Microsoft’s purchase of the start-up responsible for list-making app Wunderlist, which it scrapped after incorporating elements of its platform, is an example – have faced little regulatory scrutiny up to now.11

Making matters worse, existing business regulations often cement larger firms’ competitive advantage because they can easily afford the costs of compliance, while smaller companies face a greater relative burden.

“If you look at banking after the financial crisis, the regulations are stricter but the barriers to entry are higher than ever,” says Stephanie Niven, global equities fund manager at Aviva Investors. “And in technology, the introduction of General Data Protection Regulation in Europe has only further entrenched the competitive advantage of the big tech firms.”

Monopoly and monopsony

Why does all this matter? Leading companies tend to be more profitable not just because they lack competition, but because they are well-run, efficient and innovative. A company’s dominance may even bring societal or economic benefits. Take Google: the company’s pre-eminence in search is one reason its technology is so effective, because the more users it has, the more powerful its algorithms become.

Similarly, few would argue the world would be better off without Apple’s iPhone or Microsoft’s Office software – especially as these technologies are enabling the world to stay connected under the coronavirus lockdown. Unlike Standard Oil in the early 20th century, these firms do not appear to be using their dominance to extract excessive prices from customers – the key consideration on which modern anti-trust law rests.

A lack of competition may be hurting consumers in some industries

Nevertheless, a lack of competition may be hurting consumers in some industries. Take broadband networks. In the US, 75 per cent of customers only have access to one high-speed internet provider; the others typically only have two to choose from. The average monthly cost of connection is $68, compared with $35 for the equivalent connection in most other advanced economies, where there are more providers.12

A similar trend is evident in mobile phone plans. The economists Maria Faccio and Luigi Zingales argue US consumers would gain $65 billion each year if American mobile service prices fell in line with the German equivalent.13

A recent study from the International Monetary Fund (IMF) found mark-ups have risen across a range of industries over the last two decades. These price hikes are correlated with rising market concentration, as the largest incumbent firms are responsible for most of the price increases over the period (see Figure 2). The trend is evident across advanced economies and in different sectors, although it is most pronounced in the US.14

Philippon estimates that in 2018, the goods and services consumed by a typical household cost five to ten per cent more than would have been the case had competition remained as healthy as it was in 2000. He believes this is a key reason why the American middle classes feel under increasing financial pressure.15

Figure 2: Markups among the largest firms
Markups among the largest firms
Source: IMF 2019
Figure 3: Share of total revenue accounted for by top-decile firms
Share of total revenue accounted for by top-decile firms
Source: IMF, 2019

Among the forces at play here is “monopsony” – the monopoly power of a buyer in a particular market. As the dominant force in publishing, Amazon can effectively set the price of books, for example. But monopsony is also a problem in labour markets, allowing powerful companies to set wages and restrict the movement of labour.

In depressing overall investment, raising prices and weakening labour at the expense of capital, the lack of competition could be contributing to a deeper economic malaise. Hearn’s research indicates it is related to a litany of problems, including “low business dynamism and start-up rates, higher consumer prices, low wages and precarity for many workers, higher inequality, lower productivity growth, low economic growth despite record fiscal and monetary spending, and fragility in economic systems, making them more susceptible to exogenous shocks”. She fears the COVID-19 crisis may only worsen these effects.

Investment implications

For investors in the largest firms, their dominance may not seem the most pressing problem – as Warren Buffett quipped, an unregulated monopoly is in some ways the ideal investment. But the concentration of market power among a few companies could be creating new risks.

As industries become consolidated around a few large companies, markets become more vulnerable to external shocks – or less “anti-fragile”, to use the risk theorist Nassim Nicholas Taleb’s term.

Monopolists and oligopolists inherently become price makers and extract value from every part of the value chain

“One of the most fundamental concepts in investing is diversification. Yet investors have complacently sat idly by – in fact, gleefully welcomed – industry concentration because they thought it was good for returns,” says Hearn. “Monopolists and oligopolists inherently become price makers and extract value from every part of the value chain: workers, suppliers, consumers.” In the long run, this homogenises the marketplace so that it becomes “incredibly susceptible to shock”, she adds.

The pandemic-related disruption has illustrated the vulnerability of some industries to unexpected events. Consider the supply chains for gadgets such as smartphones and televisions, which have become concentrated at various points. Gumi Industrial Complex, located just outside Daegu, the city at the centre of South Korea’s coronavirus outbreak, produces most of the world’s memory chips and LED displays, including screens for the latest iPhone and other smartphone models. Virus-related cessation in work at this facility is expected to lead to at least a ten per cent fall in global smartphone shipments this year, hurting a clutch of large tech companies, including Apple and Samsung.16

“Supply chains are so integrated and efficient these days, there is less flex when there is an issue in one part of the world,” says Alistair Way, head of emerging market equities at Aviva Investors.

The value equation

Over the longer term, there is the risk of a political backlash against larger firms, especially if these companies are seen to have consolidated their power and boosted their profits during a time of general hardship. Calls may grow to rein them in, as in the era of the muckrakers and the robber barons.

Governments that have assumed emergency powers to deal with the pandemic may be emboldened to tackle corporate giants in the wake of the crisis. The policy measures recommended by Hearn and Tepper in The Myth of Capitalism include beefed-up anti-trust regulation, tighter merger enforcement and limits to vertical integration.

Companies’ freedom to aggressively avoid paying tax or snap up smaller competitors may be constrained

Companies’ freedom to aggressively avoid paying tax or snap up smaller competitors may be constrained. New regulation, similar to the Sherman Antitrust Act that reined in Standard Oil, could be used to classify tech firms as public utilities, like water or energy suppliers, and subject them to more onerous regulation; or perhaps, as Philippon suggests, users will begin demanding compensation for the personal data they currently provide for free.

With these scenarios in mind, Parkinson says it is important for long-term investors to focus on the value a company provides for consumers and wider society, not just the returns it offers shareholders.

“Even if a company looks like it has an unregulated monopoly, there is always a tacit societal contract that constrains how it can act and how much money it can make. Businesses need to stay on the right side of the ‘value-for-money’ equation,” he says.

Parkinson cites Google as a company that continues to offer value for customers, whereas he believes it is more difficult to make the case for Facebook, which has been mired in a series of scandals in recent years. Research led by Erik Brynjolfsson, director of the Initiative on the Digital Economy at the Massachusetts Institute of Technology, backs this up: when asked how much money they would have to be paid to forgo search engines for a year, respondents offered an average figure of $17,500; to retain access to Facebook, they were willing to pay less than $600.17

Stakeholders and ecosystems

A similar assessment of value applies when considering a company’s wider function and responsibilities in society. Before the COVID-19 pandemic hit, the corporate world had been engaged in a debate about the importance of “stakeholder capitalism”. There was growing consensus around the need for companies to do more than simply keep shareholders happy.18

The pandemic starkly illustrates that businesses are only as resilient as the environment in which they operate

The pandemic starkly illustrates that businesses are only as resilient as the environment in which they operate, and market competitiveness is one indication of the health of that environment.

”Companies that engage in aggressively anti-competitive measures – and use their dominance to exploit consumers and employees – ultimately weaken the system as a whole, according to Mirza Baig, Aviva Investors’ global head of governance.

“Companies operate within an ecosystem: that ecosystem includes customers, employees, suppliers; there is no business without those relationships. Companies may be less reliant on employees than they were 50 years ago, but you cannot run a business with an algorithm.

“The demise of market competition can be seen as part of this wider context. Unless companies and governments work together to address this, you will lock in instability in the economy and society. Investors need to accept that regardless of near-term headwinds for profitability, it is necessary to rebase views on the fair distribution of economic value,” Baig adds.

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References

  1. ‘The pandemic shock will make big, powerful firms even mightier’, The Economist, March 28, 2020
  2. Peter R. Orszag, ‘The pandemic will make big companies more dominant than ever’, Bloomberg, April 27, 2020
  3. Yael Selfin, ‘Zombies in our midst’, KPMG, May 15, 2019
  4. Carmen Reinicke, ‘The global oil price war is pushing highly indebted US shale companies toward default’, Business Insider, March 12, 2020
  5. Anjli Raval and Robert Smith, ‘Oil majors raise $32 billion of debt to weather crisis’, Financial Times, April 5, 2020
  6. Miles Kruppa, James Fontanella-Khan, ‘Big Tech goes on pandemic M&A spree despite political backlash’, Financial Times, May 28, 2020
  7. Denise Hearn and Jonathan Tepper, ‘The Myth of Capitalism: Monopolies and the death of competition’, Wiley, 2018
  8. ‘The rise of the superstars,’ The Economist, September 17, 2016
  9. Thomas Philippon, ‘The Great Reversal: How American gave up on free markets’, Belknap Press, 2019
  10. Jonathan Haskel and Stian Westlake, ‘Capitalism Without Capital: The rise of the intangible economy’, Princeton University Press, 2017
  11. Richard Waters, ‘Big Tech’s “Buy and Kill” tactics come under scrutiny’, Financial Times, February 13, 2020
  12. Thomas Philippon, ‘The US only pretends to have free markets’, The Atlantic, October 19, 2019
  13. Thomas Philippon, ‘The Great Reversal: How American gave up on free markets’, Belknap Press, 2019
  14. ‘Chapter 2: The Rise of Corporate Market Power and its Macroeconomic Effects’, World Economic Outlook 2019, International Monetary Fund, April 2019
  15. Thomas Philippon, ‘The US only pretends to have free markets’, The Atlantic, October 19, 2019
  16. June Yoon, ‘Lex in depth: why coronavirus spells trouble for smartphones’, Financial Times, March 19, 2020
  17. ‘How much are search engines worth to you?,’ MIT Sloan School, May 26, 2019
  18. ‘Cwtch: Has capitalism gone cuddly?,’ Aviva Investors, February 18, 2020

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