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Pivoting the Business - Wilmington Trust Market Forecast 2021
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Industry Consolidation

Survival of the fewest? Market power is greater in the hands of those inhabiting a sparser landscape, with increasing company consolidation over the past 20 years, and now accelerated by COVID-19. Here, we reveal the possible implications for shareholders, consumers, and business overall, as well as potential portfolio impacts.

Picture of Meghan Shue
Contributor

Meghan Shue, Head of Investment Strategy for Wilmington Trust Investment Advisors, Inc. View bio

Picture of Evan Kurinsky
Contributor

Evan Kurinsky, Research Analyst for Wilmington Trust Investment Advisors, Inc. View bio

Years in the Making

Industry consolidation—the trend of more and more market power in the hands of fewer companies—is not a new phenomenon in the public equity markets. One perspective: The combined market capitalization of the five largest S&P 500 constituents has risen to nearly 25% from approximately 10% just four years ago.

Move the slider to see how the top five stocks' total market share of the S&P 500 has grown. Click on the timeline to see how the top five stocks' total market share of the S&P 500 has grown.
Timeline goes from 1996 to 2020.
1996
2020 Top five stocks
2020
2020 Pie Chart
2020*
Market cap
% of entire S&P 500
1.
Apple
$1,912B
7.0%
2.
Microsoft
$1,570B
5.7%
3.
Amazon
$1,567B
5.7%
4.
Alphabet
$928B
3.4%
5.
Facebook
$726B
2.6%

A broader way of viewing how “top heavy” the U.S. business landscape has become in the last two decades is the Herfindahl–Hirschman Index (HHI), a measure of market share held by public companies, where an index reading of 0 indicates perfect competition, and a reading of 10,000 indicates a perfect monopoly with just one company in the whole economy.

Chart showing monopolistic trends from 1972 to 2014 using the HHI measure of market concentration. The key points follow: In 1982 The breakup of the Bell System monopoly sarted a downward trend from 1,300 HHI to 950 HHI in 1985. In 1996 The Telecommunications Act enabled broader networks and lead to a wave of mega mergers, starting an upward trend from 940 HHI to 1,100 in 1999. The upward trend continued after the Gramm Leach Billey Act that allowed banks and insurers to consolidate. In 2008 the global financial crisis lead to a domino of bank failures so the big got bigger and fewer resulting in an HHI of 1,500. By 2014 the HHI hit nearly 1,700. Chart showing monopolistic trends from 1972 to 2014 using the HHI measure of market concentration. The key points follow: In 1982 The breakup of the Bell System monopoly sarted a downward trend from 1,300 HHI to 950 HHI in 1985. In 1996 The Telecommunications Act enabled broader networks and lead to a wave of mega mergers, starting an upward trend from 940 HHI to 1,100 in 1999. The upward trend continued after the Gramm Leach Billey Act that allowed banks and insurers to consolidate. In 2008 the global financial crisis lead to a domino of bank failures so the big got bigger and fewer resulting in an HHI of 1,500. By 2014 the HHI hit nearly 1,700.
1
Breakup of the Bell System monopoly into "Baby Bells"
2
Telecommunications act of 1996 enabled broader networks and led to a wave of mega-mergers
3
Gramm-Leach-Bliley Act of 1999 allowed banks and insurers to consolidate as "financial holding companies"
4
Global financial crisis led to a domino of bank failures so the big got bigger and fewer

Shows HHI concentration index for all U.S. publicly traded firms that appear in the CRSP-Compustat merged dataset. HHI—measure of market concentration, can range from 0 to 10,000. Used by the U.S. Department of Justice for evaluating potential mergers (2,500 considered highly concentrated). One firm = 100% share = 10,000 HHI = perfect monopoly. Thousands of firms = 0% market share = 0 HHI = perfect competition. Source: G. Grullon et al., 2019.

Bigger and Bigger

Looking at the entire market of U.S. publicly traded firms, the business landscape is the most concentrated it has been in the last 40 years and has increased in more than 75% of U.S. industries as the big keep getting bigger.1 Click on the plus signs for a deeper dive.

Interactive
media & services

Alphabet (Google’s parent) and Facebook account for 93% of industry revenues. Both have been subject to recent regulatory scrutiny from authorities over their commanding presence in respective markets.

Diversified Financial Services 99.8%
99.8%
Diversified financial services
Automobiles 99.2%
99.2%
Automobiles
Interactive media & services

Alphabet (Google’s parent) and Facebook account for 93% of industry revenues. Both have been subject to recent regulatory scrutiny from authorities over their commanding presence in respective markets.

Air Freight & Logistics 93.9%
93.9%
Air freight & logistics
Technology Hardware, Storage & Peripherals 93.9%
93.9%
Technology hardware,
storage & peripherals
Multiline Retail 87.8%
87.8%
Multiline retail

Pharmaceuticals 83.7%
83.7%
Pharmaceuticals

Aerospace & Defense 73.2%
73.2%
Aerospace & defense

How we got here

To what do we owe this increase in market concentration over time?
We point to three key factors:

Falling interest rates, which make it cheaper to issue debt to pay for, among other things, strategic acquisitions. Between 1998 and 2019—a period that saw the 10-year yield fall from about 5.5% to just 2.0%—annual global merger activity more than doubled to 30,519 deals per year.2

More relaxed antitrust enforcement, which has permitted the combination of large high-profile firms in banking, airline, and technology industries.

Structural and evolving changes in labor, technology, regulation, barriers to entry, and production costs for certain industries.

Chart showing antitrust case filings by year from 1994 to 2020. most years fall between 40-60 with the following exceptions: 1996, 1998, 1999, 2000 had 85 filings each. 2008 had 77 filings. 2010 had 90 filings. 2011 was the highest year with 112 filings. 2017 to 2020 marks a downward trend with filings between 35 and 42 with 2020 the lowest year at 30 filings.
Present state: deal or no deal?

The Great Pandemic and subsequent recession have led to a collapse in M&A activity of 55% year over year for the first half of 2020. This decline in deal activity is typical of a recessionary period, but is being exacerbated by high levels of health-related and economic uncertainty, the inability to perform in-person due diligence from a business culture and other perspectives, along with restricted financing from banks. We expect activity to rebound quickly, particularly given the reduced probability of dramatic changes to corporate tax policy if Republicans retain control of the Senate. If that is ultimately the case—no matter who the president is—the status quo will likely be maintained, and the trend toward consolidation continued. With a Democrat-led Senate and a Biden presidency, however, expectations of higher taxes will likely lead companies to quickly get ahead of any expected tax changes, pressing the “pause” button thereafter.

Chart showing global M&A deal volume, year-over-year percentage change from 1998 to 2020. The first half of 2020 shows the largest negative change at 54.6%.
Where are we headed?

We expect an increased level of M&A and an acceleration of industry consolidation trends for the following reasons:

Even lower rates: The 10-year Treasury yield climbed from the pandemic lows of 0.6% but remains depressed versus history.3 Low rates permit higher debt levels, and M&A can be an acceptable use of cash during economic weakness when dividends and buybacks are either not permitted or frowned upon. Positive vaccine developments could result in rates continuing to rise, but with the Fed on the sidelines, we believe the interest rate backdrop will remain conducive to M&A.

Increasing tech needs: Companies need to build out tech capabilities and they need to do it quickly. The easiest way to do this may be, in some cases, to acquire or be acquired.

Bankruptcies: Moody’s projects in its baseline scenario that the global default rate will peak at 8.7% in the first quarter of 2021, compared to a long-term average of 4.1%. While below the global financial crisis peak of approximately 14%, expected defaults are in the range of prior recessions and could leave certain industries like business services and tourism feeling the most pain.4

Cash balances: Corporate cash on balance sheets stands at $2.4 trillion, the highest level in decades, and could be deployed by management to acquire weaker balance sheet companies. In the case of private investors, record cash balances of $2.5 trillion could be used to fund start-ups or sponsor-driven leveraged buyouts, breathing new life into the number of smaller companies post recession.5

A nuanced picture

The business landscape is far from a one-size-fits-all situation. Different sectors are likely to see different levels of strategic merger activity based on balance sheet structures, cost pressures, stress levels, and strategic interests.


Technology

Energy
Technology

Large-scale mergers between big tech companies are unlikely given regulatory scrutiny, but continued acquisitions of smaller players are likely. After all, Facebook, for example, already lays claim to approximately 37% of the global population as its user base.6 Additionally, a wave of tech-related acquisitions has raised the antennae of regulators in both the U.S. and Europe, with the European Union General Data Protection Regulation taking effect in 2020. Though tech company management teams may wish to pursue strategic partnerships and acquisitions given high levels of cash on balance sheets and a fast-paced, evolving industry landscape, they may face the highest regulatory hurdle of any sector.


Financials

Health Care


Retail

Communication Services


Industrials

U.S. vs. Europe

Large-scale mergers between big tech companies are unlikely given regulatory scrutiny, but continued acquisitions of smaller players are likely. After all, Facebook, for example, already lays claim to approximately 37% of the global population as its user base.6 Additionally, a wave of tech-related acquisitions has raised the antennae of regulators in both the U.S. and Europe, with the European Union General Data Protection Regulation taking effect in 2020. Though tech company management teams may wish to pursue strategic partnerships and acquisitions given high levels of cash on balance sheets and a fast-paced, evolving industry landscape, they may face the highest regulatory hurdle of any sector.

Chart showing that the least leveraged (indebted) industries have the most capacity to make acquisitions and drive further consolidation, based on a 0-8 scale of earnings before interest, taxes, depreciation and amortization. Progressing from most leveraged to least leveraged the order shown is: Real estate at 7 , Energy at 5.5, Utilities at 5.2, Consumer discretionary at 4.9, Industrials at 4.5, Staples at 3.1, Materials at 3, Healthcare at 3, Communication services at 2.9, and Technologu at 1.8
What this may mean for your portfolio

There are several possible ramifications of an increase in industry consolidation:

More concentrated industries can contribute to higher, short-term returns. A 2019 study showed that, from 2001–2014, an investment strategy consisting of buying industries with concentration increasing at the fastest rate, and shorting industries with the lowest relative change in industry concentration, produced excess returns over a benchmark ranging from 6.6% to 8.2% per year.7 This may be because greater industry concentration gives the largest firms in that industry more pricing power and higher profit margins.

M&A activity during periods of economic weakness has historically generated higher returns. According to a Boston Consulting Group analysis of private and public market deals from 1980–2018, two years after an acquisition, buyers’ relative total shareholder return (RTSR) is significantly higher (and positive—by a margin of roughly 9.6%) for deals done in a weak economy than for deals done in a strong economy.8 The intuitive reason here is that acquisitions completed in a weak economy give the acquirer a better bargain as lower stock market valuations can reduce the risk of overpaying for strategic assets.

Over the long term, however, if linked to reduced competitiveness and lower productivity, higher industry concentration can exercise a downward influence on portfolio returns broadly. Strategic alliances and mergers are almost always executed with the intention of increasing the individual firm’s competitive edge through cost synergies and higher profitability. However, research9 has found that, if an industry becomes too concentrated, it can have the effect of reducing competition, innovation, and long-term economic productivity. For example, if a firm becomes too big in a particular industry, that firm may stifle competitors while becoming less incentivized going forward to take risk, innovate, and invest to drive economic productivity long term. The linkage between industry concentration and competition is complex. The fast-paced and rapidly evolving technology landscape, where new business models and entire industries are being created all the time, further complicates the issue.

1. G. Grullon et al., “Are US Industries Becoming More Concentrated?” April 23, 2019. Review of Finance
2. Institute for Mergers, Acquisitions and Alliances; Federal Trade Commission
3. Bloomberg
4. Moody’s Investor Service
5. Epiq Global, “Chapter 11 US Commercial Bankruptcy Filings up 17% in August,” 9/4/2020; https://www.epiqglobal.com/en-us/about/news
6. As of 4Q 2019, Facebook had over 2.5 billion global monthly active users with a cumulative total of 2.89 billion users accessing any of the company’s core products: Facebook, WhatsApp, Instagram, and Messenger on a daily basis; https://www.statista.com/statistics/264810/number-of-monthly-active-facebook-users-worldwide/
7. G. Grullon et al., 2019
8. Boston Consulting Group, https://image-src.bcg.com/Images/Delving%20Deeper%20in%20Downturn%20M-and-A_Infographic-Dec-2019_tcm26-235712.pdf
9. Declining Competition and Investment in the U.S., NBER, July, 2017

Head of Investment Strategy Meghan Shue shares her insights on the trend of industry consolidation—what's shrinking, what's growing, where, and why.

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