In the post-crisis years, rising corporate profits have been a feature of the economic landscape. Strong and recurring profits are, however, specific to a relatively low number of superstar firms that are increasingly dominant in every sector of the economy. The phenomenon is not limited to the few, much discussed mega-tech industries captured under the FAANG acronym.
In a recent video recorded at our Investment Forum, Jan De Loecker, professor of economics at KU Leuven and visiting professor at Princeton, discussed the rise of superstar firms and some of the implications of this development, including the consequences for labour markets, and by extension for investors and policymakers.
The trend is characterised by industries becoming more concentrated over time and companies attaining a large market share with relatively few workers (thanks to the application of new technologies). As they take the ground away from under the incumbents (think of your local bookstore) these companies take a disproportionate share of economic profit. Superstar companies are distinguished by the following features:
- They capture a greater share of income and pull decisively away from the following pack
- They exhibit relatively higher levels of digitisation and greater skilled labour and innovation (robotisation, artificial intelligence, etc.) intensity
- They are more plugged into global flows of trade, finance, and services
- They have more intangible assets than peers.
Source: ‘Superstars’: The dynamics of firms, sectors, and cities leading the global economy; McKinsey Global Institute; October 2018
The superstar firm effect: rising margins, downward pressure on wages
De Loecker explained at the Investment Forum that the increasing industry concentration enjoyed by superstar firms is reflected in rising margins. Market power allows them to raise product prices, or keep them unusually high. Their status (size) as key customers enables them to negotiate lower supplier costs and their standing as a significant employer or technical innovator strengthens their ability to apply downward pressure on wages for low-skill labour.
As a result of this dominance and market control, profits per employee can rise sharply, boosting superstars’ share of the pie when it comes to total profits (see exhibit 1 below) and cutting into the overall share of gross domestic product (GDP) going to workers.
Superstar companies: in a class of their own
To illustrate this point, McKinsey research has found that 20% of US companies are lumbered with massive economic losses, 60% have practically no profit and the top 20% take practically all the value created. In addition, only a few companies – one in 12 – manage the jump from the middle tier to the top.
Does this matter to investors?
Looking at the stock market performance of some of the behemoths of our age, the answer would be ‘yes’ (see exhibit 2 below).
Investors are often attracted by growth stories, especially when growth comes on the back of industry concentration and is profit-enhancing. Consolidating industries can create appealing opportunities: you could invest in the beneficiaries of M&A, be they buyers of rivals or the actual or perceived acquisition targets.
Interesting opportunities typically involve industries in transition,
- where the benefits of consolidation have yet to fully materialise,
- where increased pricing power has yet to play out and
- where the share prices does not yet reflect the strategic appeal of target companies.
In addition to protecting margins, superstar market leaders tend to benefit from resilient earnings: their profits are less susceptible to cyclical and other shocks. This should lower the investment risk, which marks a further attraction for investors.
Exhibit 2: Superstar firms have attracted investors (share prices in USD)
Data source: Macrotrends.net; May 2012-February 2019
What will happen to the superstar company trend?
Superstars come and go – Nokia and Blackberry are but two examples. However, consolidation looks set to continue amid the allure of efficiency gains and the appeal of buying rivals as a way of tackling a competitive threat. Other drivers of ‘super-sizing’ include the need to deal with margin pressure, to gain a foothold in new markets, insource innovations or justify the research and development spend.
Finally, globalisation is likely to run further given the complexities of current supply chains, the interdependence of industries and reliance of countries on trade. It seems reasonable to assume that at best, the current nativist push may only slow globalisation. Breaking the mould seems an unlikely outcome. Thus, the forces driving the superstar firm phenomenon, such as technological change, are set to persist, allowing top firms to continue to expand, while reducing costs.
Will superstars have “their wings clipped”?
Constant innovation sprouts new ideas and with them, start-ups – often nimble outfits spotting gaps in the market the superstars left open. Furthermore, superstars could come under regulatory pressure to curb their (near-) monopolistic market dominance and contain anti-competitive consolidation (a point in case, the EU has recently blocked the planned GE-Alstom merger).
Public opinion might target superstars perhaps for their protective lobbying efforts and (perceived) influence peddling. Their outsourcing of labour, the large-scale use of temp staff and freelancers, or their (perceived) appetite to block new challengers might also fan resentment and a buyers’ strike. And at the consumer level, superstars could face criticism of their pricing and wage bargaining power.
In an age where concerns over ethics and inequality have become more vociferous; and investors are paying increasing attention to stewardship, the social aspects of business, proper governance and inclusive growth; superstar firms can expect heightened scrutiny from consumers, investors and policymakers.
Market concentration has, in part, been behind disruption at the ballot box. The phenomenon of superstar firms is also a contributing element to the rise of populism and discontent at the ballot box. Labour’s declining share of profits, stagnating real wages and the rise of the gig economy have already had major political implications in the former manufacturing heartlands in the US and Europe.
We cannot exclude the scenario whereby the next wave of technological change exacerbates the concentration of corporate power and aggravates divisions in our societies. If this were to be the case, more imaginative solutions may be required than our existing political institutions can currently provide.