The Corporate World Has Its Own Inequality Problem
(Bloomberg Businessweek) -- Liberals have a blind spot about inequality. They decry disparity between individuals—the fact, for example, that the 10 richest people in America have more money than the bottom 160 million. But they overlook inequality among companies, instead viewing Big Business as a troublesome monolith. During the 2016 presidential campaign, Senator Bernie Sanders of Vermont occasionally tarred business with a broad brush, once saying the chiefs of large multinational companies “ain’t going to like me.”
The surprising truth is there’s as much inequality among large companies as there is among people. As with individuals, a handful of companies make the lion’s share of profits, while struggling companies do so poorly they actually destroy value for their shareholders and debtholders. In the middle is a stressed-out majority: unable to keep up with the best, while pressured by the desperate tactics of the worst.
Inequality in the corporate world isn’t new. Perfect competition—with millions of small, roughly equal businesses battling it out on a level playing field—was never more than a teaching device in intro economics textbooks. What’s new, though, is that the polarization is increasing. The rich businesses are getting richer and the poor poorer.
A 2018 study from McKinsey Global Institute analyzes 5,750 companies around the world that have $1 billion or more in annual revenue and account for roughly two-thirds of all global pretax profits. The institute—the think tank of the global consulting firm McKinsey & Co.—calculates that the best-performing 10th of the companies captured about 80 percent of all the economic profit in 2014 through 2016, up from 75 percent a decade earlier. The top 1 percent of the companies captured 36 percent.
Those extreme winners—McKinsey doesn’t name names, but the group obviously includes the likes of Apple, Facebook, and Microsoft—are the companies Sanders focuses on. But for people in the business world, equally important are the losers in the fight for market share and profitability.
Those laggards are doing surprisingly badly. “The bottom 10 percent destroy as much value as superstars create,” McKinseyites Sree Ramaswamy, Michael Birshan, James Manyika, Jacques Bughin, and Jonathan Woetzel wrote in an April article on the McKinsey website. The worst of the worst, about the bottom 2 percent, are technically “zombies”—finance lingo for companies whose cash flow doesn’t cover their interest expenses.
In between the superstars and the losers are all the rest of the companies, running around like extras in a disaster movie trying to avoid getting crushed. “If you’re a middling company, you’re essentially being squeezed at both ends,” Ramaswamy says in an interview. “It’s becoming harder to survive and grow.”
McKinsey uses economic profit—how much a company earns above its cost of capital—as its measure of performance, because it captures what really matters to investors. To take an extreme example, a company that raised $100 billion in stocks and bonds and then earned just a thousand bucks in net income would still show up as profitable in the books reported to the Securities and Exchange Commission. But such a puny return on invested capital would disappoint the investors who bought its equity and debt. Economic profit adjusts for the returns that investors expect in exchange for the risk they take when they put in their money. That hypothetical giant earning $1,000 would have a highly negative economic profit.
A picture similar to McKinsey’s emerges in research on a bigger set of global companies by Aswath Damodaran, an accounting expert at New York University’s Stern School of Business. Instead of companies clustering around an average level of profitability, he, too, detected a bimodal distribution: As of January, he found, 8,300 big companies had strongly positive economic profit (return on invested capital exceeding weighted average cost of capital by 5 percentage points or more), while about 17,000 had strongly negative economic profit (returns trailed capital cost by 5 percentage points or more). In the profit space between those two extremes, where ordinarily you’d expect to find the vast majority of companies, he found only about 11,000—fewer than a third of the total.
This is the polarized world that economists Robert Frank of Cornell University and Philip Cook of Duke University predicted in 1995 in The Winner-Take-All Society. Their key insight was that returns in many businesses are nonlinear: A player with just a slight edge stands to win the entire pot, while a close second gets little or nothing, because why would any customer choose the second best?
Globalization exacerbated the winner-take-all phenomenon. When transportation and communication were expensive and regulatory barriers and tariffs high, each city would have its own local champions, whether brewers or piano makers or banks. Most were swept away when they were exposed to national and then international competition. Says Frank: “You can’t make an OK cellphone. You’ve got to be one of the very best if not the best to even survive.”
It’s easy to draw a line from company inequality to individual inequality: Superstar companies pay their own people well, but they are highly productive so they don’t have a lot of employees per dollar of sales or profit. And as they gain market share, employment by their competitors shrinks. Workers lose, while capitalists win. So concludes a 2017 paper by David Autor of Massachusetts Institute of Technology and four other authors called The Fall of the Labor Share and the Rise of Superstar Firms.
Ramaswamy and his McKinsey co-authors found that superstar companies do more research and development than average and rely more than average on mergers and acquisitions for growth. As for companies in the bottom profit decile, they actually do more conventional capital spending than the average big company, perhaps because they tend to be in sectors that depend more on physical capital than ideas.
Think of the plight of a wireless company like Sprint Corp., which has fewer customers paying less per month than Verizon Communications Inc. or AT&T Inc. and yet has to invest heavily in its network to have any hope of success, says Bloomberg Intelligence senior industry analyst John Butler. Again, McKinsey’s study doesn’t name companies, but Sprint appears in a Bloomberg screen of U.S. companies with the weakest performance in terms of return on invested capital vs. weighted average cost of capital. (A spokeswoman for Sprint declined to comment.)
Researchers disagree on whether superstar companies are becoming more entrenched. McKinsey says that according to its research, half the superstars lose their standing in an average business cycle. And when they fall, they often fall hard: “Over the past 20 years, 40 percent of companies that lost their top positions fell to the bottom decile of economic profit. In the most recent business cycle, more than 50 percent of superstars that lost their top positions fell to the bottom decile,” according to the April article.
MIT’s Autor says McKinsey’s figures exaggerate the likelihood that companies will rise or fall. In an email, he wrote, “We find that Superstar persistence has increased not declined over time.” Plus, he added, the superstars are getting bigger: “There’s little question that concentration is rising in many industries. That’s pretty well established by now by many independent inquiries.”
There’s anecdotal support for either argument, McKinsey’s or Autor’s. On one hand, companies such as CVS Health Corp. and Walt Disney Co. do appear to have an iron grip on power. “I just don’t see any challengers to the big companies we worry about in every sector. There’s not a lot of dynamism,” says Sally Hubbard, director of enforcement strategy at the Open Markets Institute.
On the other hand, plenty of companies that once seemed invincible have been brought low. Royal Bank of Scotland Group Plc and American International Group Inc. required government rescues in the financial crisis; energy giant Enron was felled in 2001 by an accounting scandal. As for companies going from the bottom to the top—that happens, too. Apple was nearly dead in 1997 and is now among the world’s most valuable companies. Delta Air Lines Inc. is the world’s most valuable airline just 14 years after a bankruptcy judge told its executives, “I have not heard anything that I will say remotely impressed me that you have the money, the talent, or the thought that you could successfully reorganize in this case.”
Those who say superstars are entrenched advocate strong measures—including antitrust lawsuits—to increase competition. Such steps would be unnecessary if market forces alone were strong enough to drag down the superstars. Some superstars, like Apple, produce so much cash that they use big dividends and share repurchases just to keep up with the flow. But buybacks are also characteristic of some poor performers, which hand back money to shareholders since there’s no good use for it in their shrinking sectors.
Companies that are earning less than their cost of capital can be as problematic for competitors as superstars, because their money-losing ways erode profit margins for everyone else. For buzzy startups such as Uber Technologies Inc., pricing below total cost is a temporary (they hope) strategy for building scale. For established companies that have fallen on hard times, slashing prices can be a “gamble for resurrection.” Since the stock is near zero anyway, shareholders have little to lose by taking a chance that roils the industry—think of an airline operating under bankruptcy protection. In 2017 the Organization for Economic Cooperation and Development published an economic policy paper titled Confronting the Zombies: Policies for Productivity Revival that recommended changing bankruptcy codes to more speedily shut down companies that deserve to die.
Those who worry about individual inequality might spare a thought for corporate inequality. Fixing one might help the other.
To contact the editor responsible for this story: Howard Chua-Eoan at firstname.lastname@example.org, Eric Gelman
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