Market concentration in Main Street and Wall Street

I have blogged earlier about Hendrik Bessembinder, the Arizona University Professor, whose research has shown that almost all the stock market returns over history have come from a handful of stocks. His work has been embraced by a few fund managers to justify single-minded pursuit of picking high growth stocks. As Bessembinder himself has written, it has been embraced by both sides,

One observer reacted by saying that the paper was “another nail in the proverbial stock picker’s coffin” while another interpreted the findings to support “giving yourself the best possible chance of owning a small number of outliers”... One writer pronounced that I argued that “the only way to invest is via index or exchange traded funds” while a Financial Times newspaper headline said I advocated “a shot at the moon”.

Though this is central to the assumptions of either side,

The results in this paper imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify in advance such ‘home run’ stocks, or can identify a manager with the skill to do so, remains.

He found that despite the large equity market gains over the past century in the US, most stocks were duds (see this paper),  

In fact, of the roughly 26,000 companies listed between 1926 and 2016, more than half lost money or did worse than simply holding one-month Treasuries. In contrast, about 1,000 stocks — or just 4 per cent of the entire sample — in practice accounted for all the net wealth creation over the period, or almost $35tn.

In fact, he found that these trends were increasing in the US,

The study includes all of the 26,168 firms with publicly-traded U.S. common stock since 1926. Despite the fact that investments in the majority (57.8%) of stocks led to reduced rather than increased shareholder wealth, U.S. stock market investments on net increased shareholder wealth by $47.4 trillion between 1926 and 2019. Technology firms accounted for the largest share, $9.0 trillion, of the total, but Telecommunications, Energy, and Healthcare/ Pharmaceutical stocks created wealth disproportionate to the numbers of firms in the industries. The degree to which stock market wealth creation is concentrated in a few top-performing firms has increased over time, and was particularly strong during the most recent three years, when five firms accounted for 22% of net wealth creation.

And he found that the skewed nature of stock market returns were even more extreme outside the US, 

We study compound returns to nearly 62,000 global common stocks during the 1990 to 2018 period, documenting that the majority, 56% of US stocks and 61% of non-US stocks, under perform one-month US Treasury bills over the full sample. Focusing on aggregate shareholder wealth creation measured in US dollars, we find that the top-performing 1.3% of firms account for the $US 44.7 trillion in global stock market wealth creation from 1990 to 2018. Outside the US, less than one percent of firms account for the $US 16.0 trillion in net wealth creation. These results highlight the practical implications of the fact that the distribution of long-run stock returns is strongly positively skewed.

In this context, the concentration of returns is evident in the Indian markets too. Ananth points to this article from Marcellus Investment Managers. This about profit concentration in corporate India,

A handful of companies – precisely TEN – are now taking home almost the entire PAT generated by the Indian stock market. This profit concentration in the hands of the top 10 companies has quintupled in the past decade and it has nothing to do with Quantitative Easing (QE) by central banks. Fewer and fewer companies – precisely TWENTY – now account for around 55% of the Free Cashflow to Equity generated by the Indian stock market. A decade ago, the top 20 Free Cashflow generators accounted for around 41% of India’s FCFE. Once again this has nothing to do with QE...

The top 20 profit generators in India (‘the Leviathans’) now account for 90% of the country’s corporate profits. Beyond dominating the country’s profit pool, the Leviathans also reinvest these profits far more efficiently back into their businesses. In fact... India’s top 20 PAT generators not only account for 90% of the nation’s profits, but they also take home 45% of the nation’s Free Cashflow to Equity (or FCFE, which is the amount of cash generated by a business and available to its shareholders after payment of debt, expenses, and investments). The reason for the lower share of the Leviathans in FCFE rather than PAT is because these giant companies are heavily reinvesting their PAT to fuel future growth. This reinvestment reduces their FCFE.

An earlier article in the same site points to more signatures of concentration,

The last decade has seen a steady rise in the ROE superiority of the top 20 Leviathans. In FY20, the median ROE of the top 20 Leviathans was 17.2% whereas India Inc’s average ROE was a mere 4%! This means that the top 20 firms are not just putting greater amounts of money to work, they are also applying these larger sums of money far more effectively and far more profitably than the rest of India.

 

And this about concentration in the Indian equity markets,

In the decade ending 31st December 2010, the Nifty added around Rs. 35 trillion in market cap. In these ten years, 80% of the value generated came from 26 companies and the median Total Shareholder Return (TSR) CAGR was 34% for these 26 companies. Moving forward by a decade, in the decade ending December 31st, 2020, the Nifty added Rs. 71 trillion in market cap. 80% of the value generated in these ten years came from just 16 companies whose median TSR CAGR was 21%.

The authors at Marcellus points to drivers of such market concentration - nature of intangibles or knowledge based industries compared with brick and mortar industries, network effects, self-reinforcing nature of the impacts of modern technologies, superior access to talent etc. You could add more like globalisation and emergence of global markets. 

However, all these are only part of the explanation. There is more at play. The rules of the game of modern capitalism and political systems favour the larger firms disproportionately. The taxation regime (corporate tax, capital gains/buybacks, tax deductibility on interest expenses etc), ease of financing (lower cost of capital for the largest firms), the public bailout backstop (too big to fail), public policy dominance of stock markets health over that of real markets, and so on are examples. Most disturbingly, the setting of these rules themselves are captured by the same elite companies. And therein lies the risk to the sustainability of modern capitalism.

Update 1 (10.08.2021)

Business Standard points to increased business concentration across sectors during the Covid pandemic in India. It uses the Herfindahl-Hirschman Index (HHI) scores to map business concentration (an industry with HHI of greater than 2500 is highly concentrated, and one below 1500 to be competitive).