Winner takes all investing 1 Good morning. Last week I wrote that the new Bitcoin ETF was a wretched, expensive, inefficient product that should not exist. It promptly hit $1bn in assets faster than any ETF that went before it, with the bulk of the demand coming from institutional buyers. I leave it to readers to decide whether this is embarrassment for me or for the market. On to other topics!

Superfirms and winner-takes-all investing

Will elevated stock prices persist? That question can be subdivided into several smaller ones. The one that gets most of the market’s attention currently is “will low interest rates persist?” But almost as important, and something of an obsession for this newsletter, is “will high profit margins persist?” My best guess is that they probably will , but I’m less than perfectly confident about this.

One reason to think margins will stay high is what we might call the “superfirm hypothesis” — the idea that the increase in margins reflects changes in the economy that have given rise to a small number of large firms that are hyper-productive, dominate their industries, are wildly profitable, and make their investors very rich.

But it has long been the case that just a few firms account for the great majority of stock market returns, strongly suggesting that they account for much of the profits, too. This point was made forcefully in a paper from a few years ago by Hendrik Bessembinder, with the surprising title “Do Stocks Outperform Treasury Bills?”

Surprising, because we all know that stock markets’ real returns are much higher than short-term Treasuries over almost any longish-term horizon. But Bessembinder’s’ point is that while the whole market does beat T-bills, the average stock doesn’t.

He looks at the monthly returns of all stocks listed on the NYSE, Amex, and Nasdaq between 1926 and 2016. Less than half of the stocks beat T-bills over their lifetimes in the sample. But this does not capture how uneven the distribution of returns is. Bessembinder offers this astonishing summary: I define wealth creation as the accumulation of market value in excess of the value that would have been obtained if the invested capital had earned one-month Treasury bill interest rates. I calculate that the approximately 25,300 companies that issued stocks appearing in the [sample] since 1926 are collectively responsible for lifetime shareholder wealth creation of nearly $35 trillion, measured as of December 2016. However, just five firms (ExxonMobil, Apple, Microsoft, General Electric and International Business Machines) account for 10 per cent of the total wealth creation. The 90 top-performing companies, slightly more than one-third of 1 per cent of the companies that have listed common stock, collectively account for over half of the wealth creation. The 1092 top-performing companies, slightly more than 4 per cent of the total, account for all of the net wealth creation. In visual terms, here is what the distribution of lifetime returns for the stocks in the sample looks like. The number of firms on the vertical axis, and lifetime returns on the horizontal axis (where for example “5” means a 500 per cent return):

So, the question is not why superfirms have emerged. They have been around for at least a century (note that on Bessembinder’s list of the top all-time wealth-creating stocks, General Motors is number 8, still ahead of, for example, Alphabet and Amazon). The question is why the strongest companies are even more dominant now — are super-duper firms, if you will — to such a degree that they are dragging the aggregate margins of stock indices like the S&P 500 up.

The granddaddy of all papers on this topic is W. Brian Arthur’s “Increasing Returns and the New World of Business,” published a quarter century ago. His beautifully written first paragraph is worth quoting in full: Our understanding of how markets and businesses operate was passed down to us more than a century ago by a handful of European economists — Alfred Marshall in England and a few of his contemporaries on the continent. It is an understanding based squarely upon the assumption of diminishing returns: products or companies that get ahead in a market eventually run into limitations, so that a predictable equilibrium of prices and market shares is reached. The theory was roughly valid for the bulk-processing, smokestack economy of Marshall’s day. And it still thrives in today’s economics textbooks. But steadily and continuously in this century, Western economies have undergone a transformation from bulk-material manufacturing to design and use of technology […]

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