OB Report
March 2019
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The Best Have Gotten Better

bsinclair By Benjamin Sinclair CFA, Equity Analyst, Investment Research

lead 310 croppedA decade ago, during the depths of the 2008/09 Financial Crisis, Executive Vice President, Director, Investment Research, Murray Leith’s keynote presentation at the Odlum Brown Annual Address was titled “The Best Get Better.” In it, he said:

"Because there are no quick fixes, and nobody knows for sure how things will unfold, investors need to be conservative and focus on the highest-quality investments. That means, the best-of-breed companies – the biggest companies, with leading market positions, the best management, the highest profit margins, the highest return on capital and the strongest balance sheets. These are the companies that are going to survive and thrive over the long run."

Murray continued the presentation by sharing the results of an eye-opening study by McGraw Hill. The study highlighted a symbiotic relationship between advertising spending and sales growth during the brutal recession in the early 1980s. The study revealed that companies which maintained or increased their advertising spending experienced significant sales and market share gains, while those that cut back lost market share. We favoured the best companies during the Financial Crisis because they had the financial strength to invest in their businesses during tough times.

The Rise of Corporate Inequality

The Hamilton Project, a research group, recently published a paper on the rise in corporate inequality.1 The report shows that from 1997 to 2012, the market share of the top four companies in any given industry rose almost 10 percentage points, on average. On the other hand, start-up rates, defined as the percentage of companies that are less than a year old, are currently at their lowest levels since the 1970s. In 2015, only 27% of Americans worked at small companies (less than 50 employees), down from 33% in 1987.

Research Chart 310

Along the way, the most profitable firms have become even more profitable. Indeed, since the early 2000s, the return on invested capital (ROIC) for the 75th percentile of non-financial, publicly traded firms has roughly doubled, while the profitability of the 25th percentile has stayed stagnate. In stark contrast, the most profitable firms – as represented by the 90th percentile – have seen an even bigger increase in profitability.

Not only are the best companies becoming more profitable, but their odds of staying superior are also improving. According to a recent McKinsey study,2 “very profitable” companies (defined as having an ROIC of 15-25%) in 2003 had an 83% chance of remaining very profitable 10 years later. In the previous decade, that number was only about 50%.

A Number of Causes

Perhaps the biggest reason for these trends in corporate inequality is the rising role of technology; which increases the scale advantages for companies that can afford to make the necessary technology investments. It’s no coincidence that the rising disparity accelerated after the 1990s, an era when the digital revolution gained steam. There are also regulatory effects to consider, as well-intended rules can inadvertently increase the cost for new entrants. Profitable sectors such as Technology and Healthcare also require a mastery of patent law, which is much easier for large companies to achieve. Furthermore, U.S. corporations doubled their spending on government lobbying from 1997 to 2012, as large incumbents sought to entrench their positions.

Globalization has also played a role, especially after China entered the World Trade Organization in 2001. Large multinationals have a relatively easy time sourcing low-cost production, and they are better positioned to reach international markets. As a result, small localized companies are increasingly being outmuscled by foreign rivals.

As these trends develop, companies continue to adapt by putting a greater focus on their most profitable business lines. Industry leaders gradually buy up smaller competitors, while conglomerates divest business lines that are subscale. Such actions have become increasingly necessary to compete effectively, but have also accelerated the rise in corporate inequality, thus creating a self-reinforcing mechanism.

How This Shapes Our Investment Philosophy

Always owning the best businesses may seem like a sound and successful investment strategy; however, that would be a mistake. Even the best businesses bought at the wrong prices will produce poor investment results. Such was the case with technology firms and other big U.S. businesses around the turn of the century. The S&P 500 Total Return Index (measured in Canadian dollars) is dominated by large companies and peaked in 2000. It took 13 long years for the benchmark to recover from the excessive valuations of that era before it could once again advance to higher ground.

We admired the best U.S. businesses from the sidelines in the late 1990s and early 2000s, as we felt Canadian businesses had better risk and return characteristics. However, in 2005 and 2006 we saw an opportunity to move up the quality chain and own better businesses south of the border. We sold Canadian resource stocks, which had risen in popularity and price, and bought best-of-breed U.S. businesses, whose valuations had fallen to reasonable levels.

Investing in the best has served us well. Not only did owning stronger U.S. companies provide comfort as we went through the Financial Crisis, but the businesses have performed very well since and contributed satisfying returns. The all-equity Odlum Brown Model Portfolio has tripled in value since the end of 2008.

Among the stocks we own, many have increased their market clout and contributed to the trends discussed here. For example, we have large holdings in technology giants Visa, Google and Amazon. All of these companies are global leaders with very high industry market shares. They are growing at fast rates, and are continuously widening their lead over smaller competitors. No matter what happens in the global economy, we see the momentum of such companies continuing for years, or even decades, to come.

Many of the businesses we own are more popular than they were when we first bought them, and consequently their valuations are not as compelling as they once were. Therefore, return expectations may need to be moderated. Nevertheless, we believe the best businesses will continue to get better.

1 http://www.hamiltonproject.org/assets/files/CompetitionFacts_20180611.pdf
2 https://www.economist.com/briefing/2016/03/26/too-much-of-a-good-thing

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