A March 2016 article in The Economist, entitled 'Too Much of a Good Thing?', argued that the typical mean reverting function of capitalism was not functioning in the United States.
To recap the basics of this process, high profits typically attract new entrants, after which increased competition dilutes these supernormal returns. Discouraged investor capital then heads for the exits, planting the seed for the cycle to begin again.
An observation from the consulting firm McKinsey quoted in the article supported this view: “An American firm that was very profitable (one with post tax returns on capital of 15-25%) in 2003, stood an 83% chance of still being very profitable in 2013 … In the previous decade, the odds were about 50%”
The proposed causes of this sustained corporate dominance included increased consolidation (the number of listed firms in the US has halved in the last 20 years), and an increased level of concentration within industries.
An outcome of the above shifts (to which we would add at least two additional causes, namely the decreased bargaining power of labor, and a declining corporate tax burden) has been an apparent step change in profitability. At the vanguard of this trend have been the small set of mega cap technology businesses that have risen to dominance in recent years.
Recognizing that a period of peak optimism with respect to the operating prospects of a business can coincide with a maximal level of investment risk (mainly due to the reflection of the sunny scenario in market valuation), it is important to seek correctives when times are good. One reliable behavioral guardrail can be found by reviewing the mixed history of technology investing.
Our favorite encapsulation of such irrational valuation dynamics came from Scott Mc Nealy, the ex-Chairman of Sun Microsystems, from a 2002 interview reflecting on the way in which the market priced his company at the dotcom peak:
“Two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is also very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are?"
Thankfully, valuations for today’s tech companies are more reasonable. Current technology market capitalization is supported by a far greater degree of profitability this time around.
So where are the dangers for this set of supercompanies? At present, one area we are considering carefully, given the near monopoly position of current portfolio holdings Facebook and Google in the online advertising market (together they hold a market share of approximately 85%) is the potential risk of antitrust action. The recent €2.4bn fine imposed on Google by the EU Competition Commission for exploiting its dominance in search is a salient reminder of the need for vigilance.
But it is also important that we do not let our inner pessimist blind us to extraordinary (and still-strengthening) competitive positions held by these businesses. In October 2012, when Facebook hit 1bn users, 55% used the service daily. When Mark Zuckerberg announced in June 2017 that the 2bn milestone had been reached, the fraction of daily users had increased, remarkably, to 66%. The next most popular service on the web, Youtube, with 1.5 billion regular users, is owned by Google. The continued strong growth in earnings and cash flows being generated by both businesses speaks eloquently of their extraordinary ability to monetise human attention.
For now at least, we believe, it appears to be the age of the supercompanies.