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Monopoly in question

Investors are betting that the US's giant firms will continue to grow strongly. This is a risky bet.
September 17, 2020

Who was right: Karl Marx or Robert Gibrat? This is a key question for investors, many of whom are siding with Marx.

I say so because this year has seen big rises in the prices of the US’s largest stocks.

So far this year Microsoft (US:MSFT) and Facebook (US:FB) have risen more than 30 per cent; Apple (US:AAPL) more than 50 per cent; and Amazon (US:AMZN) 70 per cent. With these and that other giant Alphabet (US:GOOGL) now on premium price/earnings (PE) ratios, investors are betting that the biggest stocks will grow even bigger – that capitalism operates as Marx said – as “an enormous social mechanism for the centralisation of capitals”.

This year’s most successful stock-pickers were those who backed these huge stocks. They have, in this sense, been Marxists.  

Marx’s view, however, has long been contentious. It contradicts a tendency identified by the French statistician Robert Gibrat in 1931. Gibrat’s law says that growth is independent of size, so large firms are no likelier to grow quickly than smaller ones. Whereas Marx envisaged monopoly power increasing over time, this law foresees the size distribution of companies staying the same.

So who’s right? Current numbers suggest it’s Marx. In recent years Apple has made a return on equity of over 40 per cent. If it can continue to make such a return on the three-quarters of its earnings that it retains, it will indeed grow quickly. Hence its high PE ratio.

History, though, tells a different story. The evidence suggests there's some truth in Gibrat's law – the main exception being that small companies might grow better than it predicts, not that big ones do.

Indeed, decline is a common fate for the latter. Consider the largest US firms in 1960. While some of those are still substantial companies such as Exxon, Ford and General Electric others fell into decline such as Esmark and US Steel. Powerful forces operate against giant firms: the law of diminishing returns and creative destruction. Tastes and technology change; competition eats away at profit margins; and new managers lack the ability of their predecessors to control and expand giant corporations.

Today’s behemoths, however, have some protections from these forces: Warren Buffett called these economic moats, defences against competition.

One is brand loyalty. For Apple, this is reinforced by peer pressure: if you have a teenage daughter you might well have heard her plea for a new iPhone because “all my friends have got one.” And we know, thanks to Robert Frank’s recent book, Under the Influence, that peer pressure is a powerful force.

Another is lock-in. When we get a new computer we buy Windows by default: it is pre-installed. And we use Facebook because that is where our friends are. Anybody could technically set up a rival to Facebook – but why would anyone use it if nobody else did? Facebook benefits from Metcalfe’s law – the fact that the value of a network is proportionate to the square of the number of users.

Related to lock-in is simple force of habit. We could buy from online retailers other than Amazon but why bother given that it has been so efficient and easy to use in the past?

Another moat is that these giants act like venture capitalists, buying up potential rivals before they become a major threat and investing in firms with good patents or growth potential. Many younger people use Instagram rather than Facebook. But Facebook doesn’t much care as it owns Instagram. And Alphabet bought Motorola Mobility partly for its intellectual property and Deepmind to strengthen its advantages in machine learning.

In this context, high valuations can be self-sustaining. In reducing companies’ cost of capital they make it easier for them to buy rivals thereby entrenching their market power. For this reason, Apple’s large cash holding isn’t necessarily a drag on its growth as it enhances its growth options – the opportunity to acquire new companies.

But there’s something else. There are massive obstacles to any company growing as big as Apple or Amazon – which is why none have done so (well, not since the two East India Companies at least). Potential rivals to today’s giants must invest a fortune in expanding facilities and marketing; must grow without letting costs get our of control; and must fend off rivals. As Liverpool University’s Charlie Cai has shown, investors have often under-rated these humungous barriers and so over-estimated likely growth. Monopolies can persist simply because it is so darned difficult for any company to grow to challenge them.

There are, then, good reasons why investors might reasonably believe that monopoly power is well-entrenched and so pay high and rising prices for it.

Equally, though, there are threats to such power. One comes from politics. Although we think of the US state as being especially favourable to big business, this has not always been the case. There have been episodic attacks upon monopolies such as when American Tobacco and Standard Oil were broken up in the early 20th century or when AT&T was split up in 1982. It’s possible that discontent with surveillance  capitalism and repressive intellectual property laws will grow more powerful, triggering a tougher regime for big tech.

A second threat is that creative destruction hasn’t disappeared. There are countless examples of well-run high-tech companies being brought down by being on the wrong side of technical change, such as Kodak, Xerox, Polaroid or Nokia. Can we really be so confident that this process has stopped?

Of course, these threats are small in the short-term. But as the American futurist Roy Amara said, “we tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Investors have lost fortunes betting that things will continue. In the 1960s, they expected non-inflationary growth to continue and got a nasty surprise when it stopped in the 1970s. In the late 1990s they piled into tech stocks in the expectation that great returns could continue – a hope that was in many cases dashed.  And in the mid 2000s we spoke of the “Great Moderation” – until the financial crisis squelched the illusion.

Even if you discount these threats, however, there is another. Even good companies can sometimes be expensive.

We know – with hindsight – that monopoly power was underpriced a few years ago, that investors were paying too little for Buffettian moats. But they might now have over-corrected this error. On current PE ratios, the big five (Apple, Amazon, Alphabet, Facebook and Microsoft) are pricing in a lot of hope. Prices could therefore fall back even if these companies continue to grow nicely, but not as fast as hoped.

MIT’s Andrew Lo has said that all investment strategies wax and wane, like population cycles in biology. The same might be true of buying monopolies.

In saying all this, I’m arguing against my usual position. Ordinarily, I support simple passive investing. But there Is now a problem with this. The big five now account for over a fifth of the S&P 500. If they fall, therefore, so too will the index. What looks like passive investment in a US index tracker is therefore a bet upon monopoly power remaining strong.

Luckily, though, it’s easy to diversify this bet by holding smaller company or private equity funds. You might want to do so – unless that is, Marx was right.