Over the last few decades, an interesting phenomenon has been puzzling top economists and analysts – the profit margins of a few large and successful companies seem to be defying gravity, soaring above the rest. One would expect the powerful forces of reversion to mean and competition to have restored this anomaly within a decade or so; after all, that is how capitalism is supposed to work. Yet, year after year of super-normal margins for the elite few demands a new explanation of what might be going on in the economy.
The excellent Philosophical Economics blog, in an intriguing post Profit Margins in a “Winner Take All” Economy, comments on this phenomenon. He links to an interesting post by Patrick O’Shaughnessy that presents the following graph showing all US stocks with market capitalization that is larger than $200 million sorted into five bins by their initial profit margins. A clear trend is visible over more than fifty years – from 1963 to 2015 – the top bin of companies remains at the top; the bottom quintile remains at the bottom. This means that the margins of already high-margin businesses are expanding whereas the margins for low-margin businesses seem to be falling even more.
Furthermore, O’Shaughnessy shows that this profit margin gap has been increasing over the last two decades in some sectors – technology and finance (see the following graph), but also in the health care and consumer staples sectors.
Coming at this anomaly from a different perspective, a recent labor productivity study conducted by OECD found that productivity of the top manufacturers – those at the “global productivity frontier” — grew at double the speed of the average manufacturing firm over the decade after 2000. This gap was even more extreme in services: firms on the productivity frontier grew productivity at a 5% rate, 16 times the 0.3% average rate. And, once again, the gap between the most productive firms and the rest has been increasing over time (see the graph below).
So what kind of companies might be occupying the productivity frontier?
I think it is highly likely that the gap between those on the frontier and the rest is about their strategic positioning vis-à-vis the digital disruption that is ongoing. In a previous post I have written about the investing implications of this phenomenon, dubbed “software is eating the world” by venture capitalist Marc Andreessen. Companies that are doing the “eating” tend to have increasing profit margins. Moreover, the very nature of digital technology tends to create a “winner-take-all” dynamic, where moats from network effects, patents, regulation, and scale economies allows a concentrated group at the top to earn increasingly higher profit margins. We have already pointed out that the profit margins of the various bins moved roughly in parallel until the late 1990s, after which the profit margins of the top bin proceeded to rise rapidly. This time-frame aligns nicely with the rise of the internet-based economy.
Conversely, it is notable that companies in the older sectors of the economy – such as the energy and materials – do not show this rising margins effect. A recent study by the chairman of the president’s Council of Economic Advisers also found that the biggest gains in profits have been among technology and drug manufacturers; their profits don’t come from tangible assets like factories and land, but from intangible assets such as software, standards, patents, and network effects. This also might explain the otherwise puzzling absence of strong capital expenditures even as the economy continues recovering steadily from the great recession – the modern digital economy just does not require that much spending on heavy equipment as the industrial economy of previous recessions.
The following diagram is my attempt to depict the on-going battle of companies in the age of digital disruption. The companies in the inner-most ring are former giants that are already dead – killed by the software-advantaged company with the arrow pointing at them. In their heyday we bought physical books at Borders, music records at Tower Records, rented movie DVDs at Blockbuster, and bought photography film from Kodak. These were the large companies of the time that failed to anticipate and adapt to the digital tsunami that has led our reading e-books, stream music and videos, and take digital pictures with our smartphone. The middle ring depicts companies we think are not yet dead but whose profit margins are under severe pressure from their software-armed foes. Again, these are giants of our times such as the venerable New York Times (and all physical newspapers), Time (and all other magazines), the big-four TV networks, medallion-based taxi companies, hotels, travel agencies, and physical retailers like Macy’s and Walmart.
I was particularly struck by fact that, even as they were in the process of losing to their digital competition, the companies in the inner ring (Borders, Blockbuster, etc.) actually looked quite attractive on traditional value investing metrics like the Price/Earnings ratio; right up to the very end!
- There is an elite set of global companies with high and increasing labor productivity as well as high and increasing profit margins.
- It is vitally important or a company to be strategically aligned with the powerful forces of digital disruption to prevent it from being “eaten”; ideally, it should be the one doing the eating.
- Value-investing grandmasters like Buffett and Munger have virtually proven the vital importance of investing in companies with long-term-sustainable competitive advantage – moats – since such companies can maintain and compound their earnings over long periods of time.
“Digital moats” are precisely those companies that at the intersection of these concepts: they are at the productivity frontier and moated in a way that benefits from the disruption caused by powerful digital trends. Examples are shown as the outer ring of the previous diagram (Amazon, Google, Facebook, Uber, Airbnb, Pandora, Netflix, etc.).
Market capitalization indexes as such the S&P 500 must, by their very definition, contain all companies that qualify by their capitalization – whether they moated or not, and companies doing the disrupting as well as those that are being disrupted. I think one can get an edge over the market by concentrating the portfolio around the elite few – the crème-de-la-crème – of companies at the productivity frontier. Of course, a great company does not automatically equate to a great investment – valuation always matters, and a myriad of company-specific issues must to be carefully taken into account before including a stock in the portfolio. Having said that, as more and more people from all over the globe get a smartphone connected to the cloud of digital services, I do think it reasonably likely that digital moats will continue outperforming the market over the next few years.
Full Disclosure: As of the time of writing this post, I am long many stocks mentioned in this post, including Amazon, Google, Facebook, Twitter. This post is not meant to be and should not be construed as investment advice of any sort. Investing is extremely difficult, the risk of permanent loss is high, and past results are meaningless in the future.