Winner Takes Most

A Look Back: An Evolved Approach in the Face of Seismic Shifts

Over the past 41 years, we have endeavored to manage our Core Equity allocation (the equity portion of our Growth & Income strategy) in a consistent and disciplined manner, yet the client portfolios we manage today look very different from those of decades earlier. We have always been flexible and agnostic regarding the market cap of our holdings, focusing instead on trying to find high quality, growing companies that we could buy at attractive prices, often because they were misunderstood by other investors or because they suffered what we believed to be a temporary setback. During the first half of our existence, client portfolios clearly had a mid cap bias because that was where we could find high quality, growing companies at discounted values. But starting roughly 20-25 years ago, client portfolios took on a decided tilt towards large caps. Why this happened is the subject of this quarter’s outlook.

Simply put, the U.S. economy has evolved over the last several decades. Industries have consolidated, and the leading, dominant companies in most industries have consistently outgrown their competitors, gaining market share and growing in size.

When analyzing companies for potential inclusion in a portfolio, we look for durable competitive advantages. This can arise from multiple sources, such as regulatory hurdles or better technology. Increasingly, scale economies have become a critical competitive advantage. Scale can have many important benefits for a company, from lower cost operations to greater negotiating power with suppliers to lower cost of capital. Often, this scale is achieved through acquisitions and the consolidation of an industry, but in many cases scale is achieved organically. To the extent that scale is a key competitive advantage, we are increasingly focused on larger, more dominant companies, hence the shift higher in our average market cap.

Multi-Decade Run of Increased Corporate Scale

The trend towards increased scale is a feature of the U.S. economy that we have noted before based on our own observations of industries, making the economic landscape of today look very different from what we observed 41 years ago when Osterweis was founded. Whether it was railroads, retail, municipal solid waste, fixed and wireless networks, outdoor advertising, trucking, health care services, banking, or technology, industries seemed to go from relatively fragmented to highly consolidated.

Hard data support our observation. A study published by NYU notes that “more than 75% of U.S. industries have experienced an increase in concentration levels over the last two decades … and the average increase in concentration levels has reached 90%.”¹

We believe there are at least three key drivers of increasing industry consolidation:

1. Deregulation of key sectors starting in the late 1970s: Perhaps surprising to some, President Carter ushered in a multi-decade deregulatory phase across many industries (Airline Deregulation Act, Motor Carrier Act, Staggers Rail Act, Telecommunications Act), and subsequent administrations enacted further sweeping deregulation of energy, banking, and communications.
2. Emergence of network-driven technology businesses: The rise of online search, social media, software, and other network-driven technology businesses has meant that single players often emerge as winners of entire industries, as network effects (a phrase we learned just 25 years ago) can dictate that the largest network offers the greatest value to each user; tying in unrelated services (e.g., free video streaming offered by telecom networks or retailers) helps further lock in customers, giving rise to the “winner takes all” or “winner takes most” phenomenon in industry after industry.
3. Ultra-low rates post-Great Financial Crisis: Low interest rates significantly reduced the cost of capital and encouraged a nearly 15-year run of mergers and acquisitions with ultra-cheap money.

Impact of Industry Consolidation: Not Always What it Seems

The emergence of large, dominant players across key sectors of the economy may prompt one to think the result is uniform: higher pricing, increased profit margins, and worse service for customers. However, the reality is much more nuanced in our experience.

There are certainly examples of highly consolidated industries where pricing has increased, raising the ire of customers. Consider the industry for aftermarket aerospace replacement parts. One company in particular — TransDigm — has grown through serial acquisitions since its founding in 1993. Roughly 90% of its products are proprietary, meaning TransDigm is the sole supplier of that part. Not surprisingly, the company has a long history of rampantly raising price, resulting in extraordinary gross profit margins of nearly 60%. This level of seemingly monopolistic pricing makes us nervous — an unhappy customer is never an outcome we welcome because it calls into question the sustainability of price increases. The U.S. government is a key customer of TransDigm, and Congress has repeatedly accused the company of price gouging. As a result, we have avoided investing in TransDigm despite the extraordinary returns, because we worry about regulatory risk.

Meanwhile, large players like Alphabet, Microsoft, and Amazon, which are under intense antitrust scrutiny both in the U.S. and abroad, receive prolific media coverage. We certainly do not ignore the antitrust risks for these companies but take a more discerning view.

Take Alphabet for example. The company is the dominant global player in online search advertising, video streaming, mobile operating systems, and a strong #3 in cloud computing. Scale is important across Alphabet because the larger the business is, the more data it can harvest to optimize targeting and deliver better, more relevant results. One might expect the company to be gouging customers. However, the company’s Google advertising unit reported price increases of just 0-1% in 2023, despite rampant inflation across the global economy. And the cost of online advertising is a tiny fraction of traditional advertising — as much as 98% cheaper. Thus, Alphabet plays an important role in reducing price in the advertising world. Of equal importance, digital advertising offers far superior return on investment versus traditional advertising. And users of the company’s products, from Gmail to Search to YouTube to Android, enjoy these services at no direct financial cost. Meanwhile, as the #3 player in cloud services, Alphabet is aggressively competing on price and eliminating fees.

It is worth noting that Interbrand’s widely followed annual list of Best Global Brands includes Apple, Alphabet, Microsoft, and Amazon in the top five, reflecting consumers’ deep appreciation of these dominant companies and the products and services they offer.

Is Regulation a Risk? It Depends

The Department of Justice (DoJ) and the Federal Trade Commission (FTC) have taken much more forceful action in recent years to rein in dominant market power. President Biden has also issued an Executive Order on Competition designed to promote competitive intensity in the corporate sector. The scrutiny spans a broad array of industries: banking, grocery, retail, airlines, health care, and many others. Big tech firms, in particular, have been under the spotlight, as regulators have brought monopolization lawsuits against Apple, Alphabet, Meta, and Amazon.

Our view is that it will be increasingly difficult for large companies to consolidate and acquire smaller competitors, as there is bipartisan support for challenging the increased industry consolidation that has taken place across the U.S. economy. Large technology companies may also have to modify certain practices like bundling products or self-preferencing. Lastly, we believe significant but manageable financial fines will become the cost of doing business for these dominant companies.

However, we think two factors limit the likelihood of U.S. regulators toppling or dismantling large domestic companies: 1) Regulators will have trouble proving many of these companies are harming customers under current antitrust law, and 2) the escalating trade war with China reduces the likelihood that domestic regulators impair U.S. competitors.

Antitrust law and precedents over the past 40+ years have focused enforcement on consumer welfare through the lens of pricing: excess pricing, price fixing, or other price manipulation. In other words, if regulators could prove that companies’ pricing behavior as a result of market dominance harmed customers, such behavior was viewed as anti-competitive. For example, ADM, the agricultural juggernaut, was brought to heel in the late 1990s for price fixing, and top executives were sent to prison.

However, the most dominant companies in our portfolio can hardly be accused of price gouging to hurt consumers. In fact, companies like Amazon and Target are constantly lowering prices for consumers, while companies like Alphabet offer a plethora of free services to customers. Admittedly, regulators like the FTC are considering other novel theories of harm to pursue antitrust enforcement — namely industry structure and anticompetitive practice. But precedents over the past 40+ years make this legal argument somewhat tenuous in our view, and we believe that price impacts are much easier to quantify and measure than industry structure and business practices.

We think the escalating trade war with China makes regulation even less likely. As part of the trade war, the U.S. government is aggressively supporting many domestic companies and industries. For example, the CHIPS and Science Act provides hundreds of billions of dollars of funding for key domestic sectors, including technology and health care. And there is bipartisan support to control or even seize TikTok, the widely loved Chinese social media company.

Given this set of facts, and the reality that many of the most dominant U.S. players are widely admired by customers — often for lowering price — we find it unlikely that U.S. regulators will take dramatic action.

Where to From Here?

Owning companies with nearly insurmountable scale advantages is a core element of our Quality Growth approach to investing. Scale helps create a wide competitive moat and often enables significant cost advantages that can be passed on to consumers and partners.

There are certainly scale players that worry us — those that use their market dominance to exercise abusive pricing, sometimes even while delivering subpar products or services. This type of behavior can elicit government intervention as angry customers complain, and it can also foster new competition that offers alternative products or services that can erode the dominant player’s competitive advantage. We seek to avoid these situations, regardless of a company’s current scale advantage.

We never ignore antitrust concerns for the companies we own, and we remain vigilant about new legal theories that can be used by regulatory authorities to undermine a company’s dominance. However, we believe that as long as a company is providing critical goods or services and regularly pleasing customers and partners through lower prices and higher quality, regulators will have a tough time dramatically impairing these companies’ business models.

Strategic Approach to Fixed Income

Our approach to investing — for both equities and fixed income — has been built around seeking high quality businesses at attractive valuations. As the U.S. economy has evolved and scale advantages have become a critical differentiator, our equity allocations have shifted from a mid cap bent towards large caps and even mega caps. However, our fixed income allocations have remained focused on midsized businesse s, as we prefer to lend to companies where we have transparency into how the funds will be utilized and where we can communicate directly with the executive team. This allows us to verify that the borrower’s incentives are aligned with our own, and we have generally found that the largest companies make that level of access difficult to obtain.

Final Thoughts

While the next 40 years will inevitably see other major shifts in the economy, we believe buying good businesses at attractive valuations will endure as a successful strategy to grow and protect client portfolios. In our equity allocations we are focused on Quality Growth companies with dominant market positions. In our fixed income allocations, we continue to lean into the inverted yield curve and invest in shorter-dated securities. We thank you for your continued confidence in our management.

¹William A. Niskanen, Cato Institute, “The Clinton Legacy,” Summer 2001

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Gregory Hermanski

Co-Chief Investment Officer – Core Equity

Nael Fakhry

Co-Chief Investment Officer – Core Equity

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income