The coronavirus crisis will separate the corporate wheat from the chaff – but stronger companies must be wary of becoming too dominant
It’s a matter of fact that markets in advanced economies have become less competitive since the start of the century, most notably in the US. If history is any guide, the economic slowdown caused by Covid-19 will only widen divisions between companies.
In the last three recessions, the share prices of US firms in the top quartile across 10 sectors rose by an average of 6pc; those in the bottom quartile fell by 44pc, according to a study by The Economist.
A similar divergence in performance is evident in this crisis. The shares of companies with large cash buffers and low leverage and debt-servicing costs have proven far more resilient than weaker rivals.
But a global recession could have much more serious consequences to the laggards than a short-term hit to their share price. Some may be acquired, but bankruptcy might be the outcome for others. This is what recessions do – they are the impetus that finally puts ‘zombie’ firms out of their misery. These are the companies who score badly on turnover, profits, margins, cash reserves and leverage – leaving them with little room to invest in the future.
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. Low rates will continue, but access to capital can no longer be assured.
The prospects are altogether rosier for technology giants, already among the world’s most profitable companies. More people are shopping online or watching streaming services; while companies in telecoms, data infrastructure and remote-working technology should be well positioned as workforces decamp from office desks to kitchen tables.
The crisis might accelerate the trend of concentration among a few firms that has characterised the last two decades. In the US, for example, the number of listed companies has halved since 1997, while profits are increasingly hoarded by the leading firms among those that remain. According to McKinsey, 10pc of public companies are responsible for 80pc of total profits globally.
One explanation for this 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. Smaller firms cannot keep up; they tend to cut investment in new ideas and processes and fall further behind. Large firms can also use their political influence to muscle out rivals.
So, does 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. 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.
But this is not true across the board. 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.
For investors in the largest firms, this 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 Nassim Nicholas Taleb’s term.
Over the longer term, there is also the risk of a political backlash, especially towards companies 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.
New regulation could be used to classify tech firms as public utilities, like water or energy suppliers, and subject them to more onerous regulation. With these scenarios in mind, 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.
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. That is in nobody’s interest.
Colin Purdie is chief investment officer, credit, at Aviva Investors