Andrew Adams, CFA, CMT, Senior Research Associate discusses public company consolidation and its impact on investors.
October 10, 2017
Is the stock market experiencing a consolidation of power among a few of the largest companies, and if so, why?
The stock market is shrinking in terms of the number of publicly-traded companies, a fact that is both a result of, and contributing factor to, the increasing importance of a select few, large companies. Since 1996, the total number of listed stocks in the U.S. has been cut in half – from 7,322 to about 3,600 – as annual mergers and acquisitions have doubled and the average number of initial public offerings per year has dropped considerably. Meanwhile, the share of gross domestic product (GDP) generated by America’s 100 biggest companies rose from about 33% in 1994 to 46% in 2013 according to The Economist, meaning not only are there fewer firms in total these days, but a small number of them are taking a greater piece of the pie.
The concentration at the top is, of course, primarily weighted toward the big technology companies, all of which have seen their products and services become increasingly integrated into the lives of their loyal customers. Through innovation, acquisition and the power of so-called ‘network effects,’ these modern-day conglomerates have built dominant, industry-controlling brands that continue to gain value as their huge user bases expand. The digital age has witnessed data evolve into the most important commodity in the world, and much of the success of these large tech companies is due to the ever-widening ‘data moat’ that exists between them and up-and-comers lacking that established network of billions of existing customers.
Should investors and consumers be worried about the growing importance of mega-cap companies?
Despite the growing importance of these technology companies, the impact of the ten largest stocks in the S&P 500 has not really changed much over the last 40 years, even if the specific names on that list have changed. The ten biggest stocks currently make up a shade over 20% of the index’s market capitalization, which is right around the average since 1980 when the more cyclical energy sector helped the ten largest companies represent a dominating 25% of the S&P 500. Today’s large tech companies also happen to be some of the most profitable, with Apple, Google, Facebook and Microsoft alone accounting for about 10% of the S&P 500’s total profits. As such, technology’s place at the top of the market is not unwarranted. Moreover, the roughly 23% of the S&P 500 that technology represents today is nothing compared to the 34% it comprised back in March 2000 at the peak of the dot-com bubble. Considering American corporate profits (as a percentage of GDP) are higher than they have been any time since 1929, elevated valuations in the stock market are warranted and investors don’t appear overly concerned.
Consumers have also benefited in a big way, with technological innovation throughout history helping to bring down costs and prices, while making lives more convenient and requiring less manual labor. Per The Economist, tech companies provide Americans and Europeans with an estimated $280 billion-worth of “free” services per year, such as search results or directions. Even the stuff customers purchase provides tremendous bang for each respective buck. In their book Abundance, authors Peter Diamandis and Steven Kotler estimate that modern smartphones contain roughly $900,000 worth of applications based on each piece of technology’s original manufacturer’s suggested retail price in 2011 dollars (video conferencing, GPS, video camera, etc.), which illustrates the value being created by tech’s game-changing companies. It’s no wonder these disrupting forces are raking in the profits and the cash.
How are the big companies using all that cash?
The success of the mega-cap stocks has not only produced extraordinary profits, but it has also left the big tech companies with unprecedented levels of cash. As of June 2017, Apple, Alphabet, Microsoft, Amazon and Facebook together held $330 billion in cash (net of debt), and the S&P 500’s corporate cash as a percentage of current assets has basically doubled since 2000. Naturally, companies have had to find effective ways to use this cash; there has been a clear uptick in dividends, share buybacks, merger & acquisitions activity, and capital expenditures over the last several years. The share buyback policies have come under some criticism since they can help artificially boost earnings and sales per share numbers. However, buying back stock has been shown to help shareholders, and that is not the only way companies have been able to grow their businesses. The five aforementioned tech firms alone spent $100 billion last year on research and development (three times more than half a decade ago). These firms are definitely investing in the future. Finally, there is an estimated $2.4 trillion in cash held by U.S. companies overseas that is just sitting there not contributing much. Should tax reform occur next year and overseas cash comes home, Raymond James estimates share buybacks and the repatriated cash could improve S&P 500 earnings by an additional 1% – 2.5%.