Why has corporate earnings growth become so concentrated?

Global share markets seem to be more concentrated as earnings growth has become scarce and focussed on a small group of mega corporations. These businesses have delivered aggressive volume growth, whilst preserving their pricing power, thanks to massive barriers to entry keeping out competitors. Investors are now asking if this growth concentration will be sustained.

“Sometimes it takes longer to create value, but if the companies generate more earnings, the stocks will ultimately reflect that.”
– Nelson Peltz, US businessman and investor

Has the share market become more concentrated?

Over recent years, the global share market has become much more concentrated around a small group of fast-growing companies. Just ten stocks now account for 30% of the US S&P 500, which represents around two-thirds of the global share market.

This partly reflects the growing role of technology and the ability of a select group of tech giants to capture the lion’s share of the value being created. In 2023 the Magnificent Seven – Apple, Microsoft, Nvidia, Amazon, Meta Platforms, Alphabet and Tesla – delivered returns of 101% to shareholders, while the S&P500 equally weighted index returned just 2.5%.

Why is such a small group of winners emerging?

Share prices are largely driven by consensus expectations of future earnings growth. This is seldom spread evenly across the economy, but over recent years profitability has been driven by innovation in just a few areas.

These sectors – especially technology and pharmaceuticals – are characterized by the rapid emergence of massive new markets, such as AI or weight loss drugs. These favour large scale operations in which early movers scale rapidly, build strong brands and bring down average unit cost. This creates significant barriers to entry which protect the profit margins of the (usually) one or two companies that establish market dominance.

This leads to the current ‘winner takes all’ environment, in which growth is highly concentrated within a handful of mega cap stocks.

What are the structural trends driving this shift?

This emergence of a small group of winners is taking place against a background of structural changes identified by Axiom Investors. These explain why there is now a scarcity of growth across the globe and are key drivers of long-term equity returns. Axiom refers to them as the 4D’s:

Disruptive innovation – the time taken to reach mass adoption has never been so short, enabling the emergence of single industry leaders which are highly profitable, creating a steep barrier to market entry.

Deglobalisation – supply chain risk and geo-political rivalry is accelerating the ‘Great Separation’ between the two largest economies, further curtailing the level of competition in markets with high barriers to entry.

Demographic change – brings labour shortages and a higher long-term neutral rate of interest, which boost the competitive advantage of profitable incumbents.

Debt – high government and corporate debt levels mean permanently higher borrowing costs, which brings a cost advantage to early industry leaders able to rapidly become cashflow positive.

Will earnings growth remain so concentrated?

In contrast to the beneficiaries of previous booms (such as internet stocks in the late 1990s) today’s winners are highly profitable and enjoy strong pricing power. This leaves them well positioned to sustain their market leadership over time, assuming they continue to innovate and properly manage regulatory risk.

The growing contribution of technological innovation and medical discovery to economic growth look set to endure, delivering above average margins and thus a high share of corporate profits.

Mega stocks showed their defensive properties during the recent period of elevated global interest rates. The effect of strong earnings growth as they captured rapidly expanding markets outweighed the textbook assumption that growth stocks are more sensitive to higher interest rates.

Moreover, it may be that lower interest rates caused by a slowing global economy will favour growth rather than cyclical or interest rate sensitive stocks.

What should investors do now?

Investors should not assume that all of yesterday’s winners will also do well tomorrow. Exciting growth opportunities also exist outside the technology sector, as the world transitions to clean energy, retail disintermediates, the ageing population spends more on healthcare and major trading blocs seek to secure their supply chains.

The Pengana Axiom International Fund identifies companies undergoing positive change which is not yet reflected in medium-term earnings expectations (and thus share prices). These bring the opportunity to deliver sustainable earnings growth, although valuation levels are always critical.