Some firms face more, or less, competition than others. Firms that face less competition are said to have more market power than their peers. But does that enable investors to profit? Or is that information already embedded in prices? LARRY SWEDROE looks at the latest evidence.
Competition between firms, and the lack thereof, is one of the most important topics in the academic literature, in the financial press, and in the halls of Congress. Fabian Hollstein, Marcel Prokopczuk and Christoph Würsig contribute to the competition literature with their May 2021 study, Market Power and Systematic Risk. They began by noting that numerous studies link market power with various macroeconomic trends in the economy, including a decrease in labour share, lower investment and lower productivity growth, an increase in capital share, a decrease in low-skill wages, a decrease in labour force participation, a decrease in labour flows, lagging innovation and a slowdown in aggregate output. They added that “these effects can be generated by market power in product and labour markets and can lead to financial instability. Even more obvious than the impact on the aggregate economy, market power has strong implications for individual firms. Firms with market power can limit production or refrain from investment. This leads to a higher stability of cash flows, and lower idiosyncratic volatility.”
Using a measure of total market similarity (a measure of the intensity of competition a firm faces in its product markets), Hollstein, Prokopczuk and Würsig investigated the impact of product market competition on firms’ systematic risk. The higher the product market similarity (tsimm), the more competition a firm faces for its products. On the other hand, a low product market similarity indicates low competition and hence high market power. For robustness, they also used the traditional industry sales concentration Herfindahl-Hirschman Index (HHI) as well as three other metrics. Their main sample period was 1989 until 2019, based on the availability of the main market power measure used in the study. Following is a summary of their findings:
- There is a strong negative link between market power and market betas — as the industry sales concentration increased, the market betas of the firms in the industry decreased significantly. The results are not only statistically, but also economically, significant. For example, the difference between the market beta of a company with a total product market similarity that is two standard deviations below the average compared to an otherwise similar company with average total product market similarity amounted to up to 0.26, which implies a substantial difference in expected returns and thus the cost of capital.
- The entire market has grown less competitive over time. The decline in competitiveness occurred mainly from 1995 until 2004. Around 2004 the aggregate total product market similarity appeared to reach a new, permanently lower level. Afterwards, it fluctuated around this level. There was a more than threefold increase in the effect during the most recent low-competition period (post-2004).
- Announcements of anticompetitive mergers lead to a significant reduction in market betas, underlining the causality of the market power and systematic risk relationship—as a company engaged in an anticompetitive merger to increase its market power, the beta decreased by a statistically significant 0.05 on average.
- Decomposing betas into parts due to cash-flow and discount-rate news, it is mainly the discount rate beta that is affected by market power. Thus, firms that face only little competition appear to be partly insulated from aggregate discount-rate shocks.
- Firms with high market power not only have lower systematic risk but also less left tail risk—creative destruction through innovation is more likely in competitive industries. Thus, firms that face more competition are likely riskier.
- Lower equity costs therefore mean that market power is in part self-reinforcing.
- Their results were robust to a large variety of measures and alternative beta estimators.
Their findings led Hollstein, Prokopczuk and Würsig to conclude: “Market betas clearly depend not only on the firm itself but also on its competitive environment in product markets.” They added: “Firms that thrive and face low competition in their product markets also appear to have lower costs of equity capital. Lower costs of capital for the most powerful companies further increases their competitive advantage. Thus, concentration in product markets appears to be partly self-reinforcing. Our findings thus joins the chorus calling on policymakers to tighten anti-trust rules and promote competition.”
For investors, the takeaway should be that the market recognises the reduced idiosyncratic risk and reduced tail risk of companies facing less competition — companies with these traits are often referred to as “wide moat stocks”. Thus, that information is already embedded in prices and is not a source of alpha. Investors that are more concerned about avoiding left tail risk could use that information to tailor their portfolios to have greater exposure to such companies (and the low beta/low volatility factor), with the understanding that they also have lower market betas.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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