This world…belongs to the strong, my friend!
It was the American actor William Redfield playing Dale Harding in the Oscar-winning film ‘One Flew Over the Cuckoo’s Nest’ who put it best. ‘This world… belongs to the strong, my friend! The ritual of our existence is based on the strong getting stronger by devouring the weak.’
The market consequences of the COVID-19 pandemic and its aftermath may still be in flux, but one aspect is unavoidable. Strong companies are very likely to get stronger still. Meanwhile, the position of weaker businesses will deteriorate further.
In part, this effect is likely to result from the stresses imposed by the pandemic. This has revealed and exacerbated existing weaknesses in businesses across the market. Indebted companies have become more vulnerable through weaker order books and cash flows. The pandemic has accelerated existing trends towards on-line commerce and manufacturing automation. Companies that were already struggling to adjust to this new world have suffered as a consequence.
The result is that the gap in performance between the top performers and everyone else has widened dramatically. According to McKinsey ‘Between December 2018 and May 2020, the top quintile of companies [as measured by economic profit] grew its total market-implied annual economic profit by $335 billion, while companies in the bottom quintile lost a staggering $303 billion’. This pattern has been evident since 2010. The COVID-19 pandemic is pushing it to entirely new levels.
This widening gap is also visible between different sectors. Sectors that were already generating above-average levels of economic profit, such as semiconductors and pharmaceuticals, have jumped further ahead. Banks and utilities have fallen further behind. The McKinsey authors point out that the Global Financial Crisis had a similar effect. Leading companies were able to deleverage, sell underperforming assets, and buy more promising ones faster than weaker rivals.
This greater flexibility may be one reason that strong companies get stronger. But another paper published in August suggests that there may be other forces at work. Economists at Princeton University and the University of Chicago Booth School of Business suggest that the long-term decline in interest rates has served to supercharge the ability of market leaders to pull ahead of their competitors. The authors observe that ‘market leaders have a stronger investment response to lower interest rates relative to followers’ in a low-interest-rate environment. This in turn leads to stronger productivity growth and greater market share.
As investors, we have identified a similar dynamic in many of the markets that we invest in. Companies with strong balance sheets and competitive products like Ansys in technology, Hikma in healthcare, and Kingspan in building materials are gaining market share and targeting their next acquisitions. To a large degree, this is healthy and welcome. Yet the Princeton and Chicago economists urge caution. More concentrated markets become less competitive. This eventually leads to falling productivity growth. For the authors, the world at large is not best served by a small number of very large companies. Regulators should enact ‘more aggressive anti-trust policy during times of low-interest rates’.
Poor Dale Harding was one of the ‘weak’ ones in the Oregon psychiatric hospital where One Flew Over the Cuckoo’s Nest was set. He had no option but to accept the complete supremacy of the ‘stronger’ characters (notably the loathsome Nurse Ratched). Thankfully the analogy ends there. The market is clearly not the equivalent of an abusive psychiatric hospital. We should expect regulators to ensure that markets work in the interests of society as a whole, and not only for the strongest.
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