The superstar firms in the spotlight

The names are household ones. Businesses such as Facebook, Amazon, Google and Alibaba are a rare breed – giant entities that are hugely profitable, influential and dominant. This handful of companies accounts for a vast share of all corporate earnings and their emergence has profound implications for the world around us and the decisions we take as investors.

The term ‘Superstar Economy’ was coined as long ago as 1981 by US economist, Sherwin Rosen. But there’s little doubt that the digital revolution has accelerated the phenomenon. It’s no surprise that this sector is where some of the true titans are found.

The rise of a superstar can be dramatic. Amazon is just 25 years old. The company took seven years to achieve its first profitable quarter and more than 12 years to clear its early deficits. But now it’s valued at a little under USD 800 billion. Contrast that with the much slower rise in more traditional sectors such as energy and capital goods, where it’s an average 80-year wait to achieve superstar status.

So, what criteria distinguish a superstar business and can these be used to identify the companies that could join the club in the future? Look closely and some common characteristics emerge:

• Heavy investment in research and development (R&D) offset by low production costs
• Strong and sustainable growth with a high degree of liquidity
• Goods or services that have mass market appeal and can be distributed globally
• A strong presence in markets that are rich with opportunity
• A substantial portion of profit reinvested to stimulate growth
• A high return on invested capital (ROIC)

With superstar status, businesses have immense power. They can cut prices to lock out competition or price goods and services below a low marginal cost curve to secure customer loyalty. Often the business is the only one recruiting labour in a particular market, so it can use its market power to constrain or even drive down salary costs. Despite these potentially favourable market conditions, we believe investing in such firms still requires significant diligence. We think so for two reasons.

The Superstar Economy is a fluid one. Research by McKinsey shows that almost half of superstars fall from grace in every business cycle. It’s tough staying at the top, more so in emerging markets where churn is even higher than in developed ones.

Then there are companies that come close to superstardom but fall short in one or two key areas, Über being a prime example. In the first quarter of 2019, Uber made a net loss of USD 1.01 billion on adjusted net revenue of USD 2.76 billion – a superstar in perception but not in performance. Similarly consider WeWork, the lossmaking provider of office space, that is preparing for an IPO. How will this company deal with a downturn in property markets? Should we value WeWork as a tech company or measure it against the far lower-rated real estate sector?

Until recent years, growth and profitability were pretty much all that was expected of major corporations. This is changing fast. Increasingly, companies are coming under scrutiny for their business ethics and commitment to sustainability – the more monopolistic their market practices appear, the more scrutiny they receive from stakeholders, governments, regulators, the media and customers. Anti-competitive practices and tax arrangements are all coming under intense examination.

In the United States, there are voices across the political spectrum suggesting that US capital markets have become too self-serving and are no longer helping non-financial business. In the opinion of many, prioritising shareholders above all should stop, and public policy should play a role in directing capital to more productive places – away from Wall Street, and towards Main Street.

If superstar companies want to retain their superstar status, they will need to convince us all that they are not just paying lip service to environmental and ethical considerations. Today, more than ever, ‘big’ business needs to be ‘good’ business.

In short, superstar firms form an elite group of the world’s biggest businesses, often with the potential for exciting investment returns. However, not all superstars are created equal. We believe the fluid nature of the Superstar Economy, coupled with the growing importance of ethical and environmental business practices, underscore the importance of research and sector expertise in seeking the true superstars – of today and of tomorrow.

For ideas on how to approach investing in superstar firms, visit Constructing a portfolio of superstars.