Bigger's Been Better

It’s never been better to be a giant company in the U.S., but will it stay that way?

If you will accept a little oversimplification, the last decade or so of global equity market performance can be summarized as follows. U.S. stocks have profoundly outperformed stocks in the rest of the world, whether other developed markets or emerging markets. This outperformance has been partially driven by U.S. P/E ratios expanding more than in other markets. But the largest driver of the outperformance has been the massive superiority of earnings growth in the U.S. relative to anywhere else. This superior earnings growth has been driven not so much by strong top-line growth, but by expanding profitability by U.S. companies relative to sales, gross profits, or other measures that can plausibly be used as proxies for economic capital. Unlike in past cycles, this rising profitability seems to have been neither a result of, nor a driver of, increased corporate investment. Digging a little deeper, we can see that the improvement in profitability has occurred only in the largest companies. These companies have been out-earning their smaller brethren by increasing margins over the past 25 years or so. The long period of their improvement suggests this effect is not something we should expect to correct over a single business cycle, but my guess is that the world in the future will be less favorable to these large, dominant companies than is true of the current environment. If we were to adjust the assumptions of margin reversion in our forecasts to account for a slower pace of this reversion, our forecast for U.S. large cap stocks (as well as high quality stocks) would improve noticeably, but the adjustment would still leave them looking meaningfully worse than the other groups of equities we forecast.

For a very long time, U.S. corporate profits seemed to be an exceptionally well-behaved mean-reverting series. Exhibit 1 shows corporate profits relative to GDP in the U.S. since 1929, with dotted lines marking the average level across the 20th century and the period 2004 to 2019.

Up through the 2001 recession, this series was remarkably mean-reverting, with the expected fluctuations across the business cycle and the only outlier occurring in the depths of the Great Depression. Sometime around 2004, however, this series experienced a decided upward shift and since then has averaged 9% of GDP versus the 6% average for the 20th century. Though it has maintained its cyclical variations, the series seems very clearly to have been varying around a different mean. This shift, as profound as it seems to have been, has not actually been that widespread among companies. Exhibit 2 shows a conceptually similar series, profits as percent of value added for corporations.1 It isn’t exactly the same as profits/GDP, but it is available on an individual company basis.

What we immediately see from Exhibit 2 is that the increase in profitability has not been at all evenly distributed. With the number of lines on the chart, however, it’s probably easier to understand the magnitudes in table form.