The Profit Story Part 2: Oligopolies On the March.
The Profit Story Part 2: Oligopolies On the March.
In my last post, I made the obvious point that stock prices are largely driven by business earnings, and the possibly more interesting point that over the past three decades business earnings materially benefited from increased trade, which weakened labor’s power. As a result, business profit margins over the last decade reached levels last seen during the golden ’50-60s era, as this picture shows:
Sources: Bureau of Economic Analysis (BEA)
I also mentioned that three other factors have been important to profit margins in recent years – (1) consolidation, (2) the “Amazon Syndrome”, and (3) government policy. In this post I’m drilling down into the consolidation story, which I hereby rename “The Oligopoly Story”. Sounds sexier, no?
An oligopoly, according to the Oxford dictionary, is “a state of limited competition, in which a market is shared by a small number of producers or sellers.” The benefit of an oligopoly to the owner – that’s you, the investor! – is power; power over customers, suppliers and employees. And that power translates into a strong profit margin. For example, Home Depot and its fellow oligopolist Lowe’s have been creaming mom and pop hardware stores and small chains for a long time. The benefit of the oligopoly to Home Depot’s investors is quite clear from this picture:
Sources: Profit margins - Company reports. Stock prices – Yahoo Finance)
Evidence of Growing Oligopolies
Has the sharp increase in business profit margins from the ‘80s to today (see first chart) been partly a result of an increase in oligopoly power? It sure looks like it. This chart shows that the share of US employees working at large companies grew since 1990:
Source: (New York Times, June 17, 2018, David Leonhardt author)
The increased company size has given companies more power over their employees. The Pennsylvania Gazette (the Penn alumni bulletin. Go Quakers!) had a fascinating article in its March/April 2018 issue. Economist Ioana Marinescu studied job postings by occupation and location. She found that:
“On average, labor market concentration is high. The Federal Trade Commission has thresholds for the product market, measured with something called the Herfindahl-Hirschman Index. In an anti-trust situation, if companies are merging and driving that metric over 2,500, that is prima facie evidence that the merger should be stopped [because of too much industry concentration]. On average we found a concentration [in job postings] of over 3,000. So most labor markets in the US are already in the high red zone for concentration.”
The benefits of creating oligopolies is almost certainly behind the steady growth in mergers and acquisitions globally:
Source: Institute for Mergers, Acquisitions and Alliances
The Wall Street Journal noted yesterday that merger activity is on pace to set a record this year.
The Counter-trend: Internet Disruption
While traditional businesses have been working diligently to create oligopolies, new internet-based companies in many industries have been working to destroy them – darn you, Al Gore! – and even create their own. This history of bookstore chain Barnes & Noble is instructive:
Sources: Profit margin – Company reports. Stock prices – Yahoo Finance.)
Bookstores used to be rundown shops managed by near-sighted guys in threadbare tweed jackets and also near-sighted gals with one too many cats. Then the suits showed up, in the form of Barnes & Noble, B. Dalton and Borders, opening in malls and putting out of business many of those poor book-loving guys and gals. Oligopoly here we come. You can see the results in Barnes & Noble’s late-‘90s profit margin expansion in the chart above.
Then some company, whose name eludes me at the moment, took book-selling online. At first, the new competition from that online seller (darn, its name is on the tip of my tongue!) wasn’t so bad for B&N. It hastened the demise of the independents and offered the hope that B&N would be the last book chain standing. But alas, that online guy (this is getting embarrassing) created its own oligopoly, leaving Barnes & N alive but barely so. Being on the short end of the oligopoly story is a sad place for an investor to be, as the above chart shows.
Where Is the Oligopoly Story Going? It’s Confusing.
On the one hand, the oligopoly story is expanding because of dominant internet companies. Google’s stock is selling at a 25 P/E ratio, Facebook at the same 25 and Netflix at 137(!) times, because they are assumed to have built durable oligopolies in their respective business niches.
On the other hand, some businesses are getting more competitive. Take the grocery store business, for example. The big chains were for years stomping on Mom and Pop food stores. Then healthy alternative like Whole Foods started muscling in. Then big-box retailers like Wal-Mart and Target decided that food is the gateway drug to getting us to buy useless junk. Then foreigners like Aldi’s and Lidl decided that Americans desperately needed them. Then that mysterious online bookseller said “If we can successfully hawk romance novels, then we can sell canned goods and endives.”
So, you should be saying, which is it? More or fewer oligopolies? I’m going with less. It seems increasingly clear to me that management and investment strategy is shifting towards sales growth over profit margins. The main reason is what I call the “Amazon Syndrome”. Wait, I got it – Amazon! That’s the dagnabbed online bookseller, right? And focusing on growth means taking a chance on challenging oligopolies, even with a weak hand.
The Amazon Syndrome is so interesting that it deserves its own post. So I’ll be back.