Of Incumbency and Profits

Since the 1940s, corporate profits have shown a tendency to mean-revert, meaning that, as a percentage of gross domestic product (or GDP), they have tended to bounce around an average of  6-6.5%.  However, over recent years, that percentage has stayed well above the historical mean, averaging 9.6% since 2010:

There has been no shortage of attempts to explain this phenomenon.  Some have linked it to the rise of globalization, an argument that makes sense as American multinationals generate as much as 45% of their sales abroad.

Another popular explanation is the effect of extraordinary Federal Reserve stimuli, namely quantitative easing, or “QE,” and zero-interest rate policy, or “ZIRP.”  This argument contends that the Fed’s actions, – in place from late 2008 through 2015, – have depressed borrowing costs for corporations, thus expanding their margins.

A third argument states that corporate America is increasingly dominated by high-margin industries such as technology and consumer discretionary companies.  Because these highly profitable companies increasingly command a greater share of the corporate profit pie, they skew the overall profits picture.  This argument makes sense, especially since shrinking sectors such as energy have seen their margins retreat.

However, it seems to me that that there are flaws with each of these arguments.  The proponents of the globalization theory look at the US in isolation, when it seems to me that a similar effect on corporate profits would be observed in other nations, particularly those with economies much more reliant on trade than the US is.  Lower borrowing costs have certainly played a part in the profits story, but there’s little evidence that Fed policy has by itself dramatically lowered interest rates.  So, while the factors laid out in these arguments have probably played a part, they seem to be wanting when it comes to providing a satisfactory explanation of just why corporate profits have stayed elevated.

The most compelling explanation, in my opinion, seems to be that laid out by the Economic Innovation Group.  The EIG recently published a study titled “Dynamism in Retreat,” which goes to great lengths in demonstrating that, since the recession of 2007-2009, corporate America has increasingly become a less competitive environment, with incumbent companies dominating the post-recession landscape.

For example, EIG notes that in “14 percent of all industries, the four largest firms claimed more than 50 percent of the market.”  Furthermore, the top firms in the most concentrated industries employed only 30% of the nation’s workforce, but they generated 40% of corporate revenues:

Source:  EIG

This dramatic concentration of American industries has led to very low corporate turnover as new entrants into the marketplace are either acquired quickly, or lack the staying power to survive in a less-competitive landscape.  EIG notes that, compared to the 1970s when there were close to 100 new companies created per billion dollars of GDP, the current number of new firms by the same measure is closer to 25.  The result is that profits have remained at levels well above where they would be when incumbent market players faced more competition.

Importantly, EIG’s study shows that this is the result of a combination of demographic trends, fallout such as risk-aversion from the recession, and the unintended consequences of new regulations.  In 2016, EIG notes, the population of the United States grew at a rate of less than 1%, which was the slowest rate since the Depression.  This, along with a slowing of immigration – immigrants are more likely entrepreneurs than natives – has led to a graying of the population, and a resultant decrease in startups.

Secondly, regulations such as Dodd-Frank, which were meant to help prevent another financial crisis, may have instead led to a dearth of lending, which new firms need as they have less access to alternative sources of capital.  This increased regulatory burden, EIG argues, along with a needlessly complex tax code, is particularly onerous for new firms, which do not yet have the scale to defray these burdens that the established incumbent firms do.

The implications, of course, for investors are probably different for the economy as a whole.  Elevated profits are certainly welcome for shareholders, especially when they come in the form of increased buybacks and dividends.  But one should not expect these conditions to perpetuate.  Potential relaxation of both the regulatory and tax burdens could spur a new wave of startups, and, immigration reform – however unlikely it seems now – could usher in a new generation of entrepreneurs.  These developments would be welcome in the long run for both investors and the economy.


Dynamism in Retreat.”  Economic Innovation Group

See also:

Business in America:  Too Concentrated.”  The Economist

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