- Between global pandemic mitigation efforts and the deepest recession since the Great Depression, the strongest companies are likely to get stronger with greater market share, increased pricing power and higher barriers to entry for would-be competitors.
- Nowhere is this dynamic more evident than in the tech sector, where calls for stricter antitrust enforcement against the biggest juggernauts have escalated in both the United States and European Union. Look for such pressure to continue.
- Also look for greater emphasis on stakeholders (customers, employees, and communities), as a singular focus on shareholders becomes a thing of the past.
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? Could public sentiment turn against the largest companies, as it did when the United States cracked down on trusts more than a century ago?
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 U.S. 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
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 categorized 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 stabilize 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
Elsewhere, lockdown conditions would seem to favor 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 United States. 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,” 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 in June announced an agreement to acquire autonomous vehicle start-up Zoox for a sum in excess of $1 billion.5
The crisis could lead to further concentration in other industries, too. Take airlines. At 40 of the largest U.S. 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.6 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 –rewarding innovative growth leaders while other businesses 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.
U.S. Census Bureau data indicates U.S. 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. Profits are increasingly concentrated among the leading firms that remain. As McKinsey research put it, ten per cent of public companies are responsible for 80 per cent of total profits globally.7
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, U.S. industries with high profits attracted more new entrants until about 2000; since then, entrants to profitable industries have fallen as the leaders pulled away.8
Hearn’s research indicates the lack of competition 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.
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.”
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, the oil trust that was broken up 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.
Nevertheless, a lack of competition may be hurting consumers in some industries. Take broadband networks. In the United States, 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.9
A similar trend is evident in mobile phone plans. The economists Maria Faccio and Luigi Zingales argue U.S. consumers would gain $65 billion each year if American mobile service prices fell in line with the German equivalent.10
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 1). The trend is evident across advanced economies and in different sectors, although it is most pronounced in the United States (see Figure 2).11
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.12
Figure 1: Markups among the largest firms
Figure 2: Share of total revenue accounted for by top-decile firms
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.
“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 homogenizes the marketplace so that it becomes “incredibly susceptible to shocks”, she adds.
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 center 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.13
“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 growing 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 “trust busting” era of the early 1900’s, or much later attempts to break up AT&T (successful), IBM and Microsoft (both unsuccessful).
If recent Congressional interrogation of tech CEOs is any indication, governments that have assumed emergency powers to deal with the pandemic may be emboldened to tackle corporate giants in the wake of the crisis through beefed-up anti-trust regulation, tighter merger enforcement and limits to vertical integration.
”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.
6 Denise Hearn and Jonathan Tepper, ‘The Myth of Capitalism: Monopolies and the death of competition’, Wiley, 2018
8 Thomas Philippon, ‘The Great Reversal: How American gave up on free markets’, Belknap Press, 2019
10 Thomas Philippon, ‘The Great Reversal: How American gave up on free markets’, Belknap Press, 2019
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL), as of December 13, 2019. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.
Aviva Investors Americas LLC (AIA) is the named subadviser to the Virtus Aviva Multi-Strategy Target Return Fund and utilizes the services of Aviva Investors Global Services Limited (AIGSL) and its other affiliates (collectively, Aviva Investors) to manage the Fund. Each affiliate entered into a Memorandum of Understanding (“MOU”) with AIA and these affiliates are Participating Affiliates as that term is used in relief granted by the SEC.]
Past performance is no guarantee of future results.
All investments carry a certain degree of risk, including possible loss of principal. Mutual Funds, ETFs, and Virtus Global Funds are distributed by VP Distributors, LLC, member FINRA and subsidiary of Virtus investment Partners, Inc.
Please consider a Fund’s investment objectives, risks, charges, and expenses carefully before investing. For this and other information about any Virtus Fund, contact your financial professional, call 800-243-4361, or visit virtus.com for a prospectus or summary prospectus. Read it carefully before investing.