Looking for an ETF to hold for a lifetime? This is it!

• The largest companies in the US are bigger than ever. Since 2000, the largest companies have been increasing their dominance of industry market share.

• The endurance of these established incumbents can be attributed to their strong competitive advantages, allowing them to fend off competition and preserve their margins.

• Armed with strong balance sheets, they have been investing in innovation at an increasing pace, and are in a better position to weather disruptive challenges from smaller companies.

• The low interest rate environment that fostered the rapid growth of small companies has also ended. As the era of easy money comes to an end, the once-cheap funding accessible by small companies is now scarce and expensive, further hampering their growth prospects.

• As such, having stakes in high-quality companies is a prudent long-term investment strategy. One convenient way to get exposure to high-quality companies is via the JPMorgan US Quality Factor ETF (NYSE:JQUA).

In the age of digital disruption, start-ups are often said to have a huge competitive advantage over established incumbents. This advantage stems from their smaller size and streamlined business models, giving them the needed agility to innovate quickly and respond to changing market trends. History is also replete with examples of how once-large companies, including Kodak and Blackberry, were brought to their heels by younger, nimbler disruptors.

The reality, however, is quite the opposite.

Contrary to the popular notion, the largest companies in the US appear to have consolidated their dominant positions over the years, with little prospect of any serious competitive disruption by smaller and newer entrants. In other words, incumbents have become more secure, not less.

There are reasons to believe that these established incumbents will continue to dominate their respective industries in the years to come. As such, having stakes in high-quality companies is a prudent long-term investment strategy, regardless of recession.

Established incumbents have further entrenched their positions

The largest companies in the US are bigger than ever.

Over the past decade, the S&P 500 Index, which tracks the performance of 500 of the largest US companies by market capitalisation, has grown faster than the economy as a whole (Chart 1). And it is the biggest of big businesses that have contributed to a larger share of the growth, with the 10 largest companies by market capitalisation comprising more than 30% of the index. Ten years ago, the equivalent figure was less than 20%. Now, the top 10 companies have as much influence on benchmark performance as the bottom 412 companies combined.

Chart 1: Market cap of S&P 500 has grown faster than the US economy

That’s just one measure of how the biggest firms have come to dominate the US economy.

Importantly, the largest companies have also been increasing their dominance of industry market share. Among the 157 primary industries monitored by S&P Global Market Intelligence, the market share of the top five companies has risen in 105 of these industries since 2000, while it has decreased in only 38. Evidently, industry incumbents have demonstrated a propensity to grow even larger, with big tech companies standing out as prime illustrations of this trend.

More than 50% of global digital ad spending now goes through Meta or Alphabet, up from 38% ten years ago. In the realm of search, Google commands a market share of over 90% globally – an unassailable lead it has maintained since at least 2009. More than 60% of the world’s cloud infrastructure is controlled by just three companies – Amazon, Microsoft, and Alphabet. Big tech’s dominance also extends into the global market for operating systems, app stores, and smartphones.

This phenomenon extends beyond the tech industry. In almost every sector of the economy — including retail, financial services, and manufacturing— it has become increasingly difficult to knock incumbents off their perches.

The combined market share of the four largest grocery retailers – Walmart, Costco, Kroger, and Sam’s Club (owned by Walmart) – in the US nearly doubled, rising from 23% in 1993 to 43% in 2022, coinciding with a significant drop in the overall number of grocery stores over the same period.

Despite the growing wave of disruption by fintech companies, the decades-long duopoly of Visa and Mastercard has only grown stronger over the years, with their combined market share in the US rising from 81% in 2007 to 87% in 2022. In the banking industry, even though there are more than 4,000 banks in the US, four of them – JPMorgan Chase, Bank of America, Wells Fargo, and Citibank – control nearly 40% of domestic deposits, up from 36.8% in 2012.

The endurance of these incumbents can be attributed to their competitive advantages, such as strong brand names, massive scale, and high customer switching costs, allowing them to fend off competition from would-be disruptors and preserve their margins. In certain industries, patent protection and regulation limitations also make it expensive for new competitors to enter the market.

Little wonder, then, that their dominance of industry market share has also led to greater pricing power and fatter margins over the years, with the median profit margin of the top 50 firms in the S&P 500 Index soaring from 11.0% in 2002 to 16.4% last year.

Financial strength will ensure continued dominance

Another reason why we think established incumbents will continue their dominance in the years to come is their sheer financial strength.

The largest non-financial companies in the US are holding plenty of cash on their balance sheets, skyrocketing from USD 679 billion in 2002 to more than USD 2 trillion today (Chart 2, as of 30 September 2023), with more than a quarter of it concentrated in the top five companies (Alphabet, Amazon, Apple, Meta, and Microsoft).

Chart 2: The largest US companies are hoarding lots of cash

Cash helps in various ways.

For a start, cash enables firms to invest in research and development (R&D) initiatives that will allow them to innovate and stay ahead of their competitors. While it is commonly believed that market concentration in the hands of a few players stifles innovation, the evidence suggests otherwise.

Despite dominating their respective industries, big companies have not been resting on their laurels. On average, a large company in the US spent USD 1 billion on R&D in 2022. Alphabet, Amazon, Apple, Meta, and Microsoft invested close to a combined USD 200 billion in R&D last year, more than 80% of their combined profits and close to 40% of all R&D spending by S&P 500 firms. Meanwhile, the average small company spent a paltry USD 35 million – clearly insufficient to keep pace with a large competitor. The difference between the mean annual R&D spending of large and small companies has also grown from USD 225 million in 2002 to almost USD 1 billion in 2022 (Chart 3).

In other words, rather than basking in their glories, established incumbents have been pulling farther ahead in innovation, helped by their huge cash piles.

Chart 3: Big firms have been pulling ahead in their R&D spending

Cash also enables firms to make acquisitions that will help them access new markets, expand their customer base, and adapt to market disruptions, further consolidating their positions in an ever-changing competitive landscape.

Microsoft’s acquisition of Activision Blizzard for USD 69 billion in an all-cash deal is a good example. Far from being a debt-fuelled acquisition, Microsoft had the cash to comfortably acquire Activision Blizzard without having to borrow at the current elevated interest rate environment. The transaction will make Microsoft the world's third-largest gaming company by revenue, further expanding its presence in the gaming industry.

Despite coming late to the e-commerce game – and nearly missing the revolution altogether – Walmart’s immense financial strength and a series of acquisitions enabled the company to quickly scale up its e-commerce operations. The retailer is now the second largest online retailer in the US, with only Amazon selling more.

Evidently, the established incumbents are thriving. Armed with strong balance sheets, they have been investing in innovation at an increasing pace, and are in a better position to weather disruptive challenges from smaller companies.

Rising interest rates will hit smaller firms especially hard

Some critics may argue that every big global company started out small. McDonald’s started out with one restaurant, but it now has more than 40,000 outlets worldwide. Amazon, Netflix, and Microsoft were, once upon a time, small companies too, but grew to be large and dominant. Many of the currently small companies will surely fare similarly.

Not necessarily.

The low interest rate environment that fostered the rapid growth of small companies has now given way to the most aggressive Fed rate hike cycle in decades. As the era of easy money comes to an end, the once-cheap funding accessible by small companies is now scarce and expensive. The Prime Rate, which is often used as the base rate for small business loans, currently stands 8.5% (Chart 4), the highest since 2000 and pushing the cost of most small business loans to as high as a 11.5% interest rate (assuming a 3% spread over the Prime Rate).

Chart 4: Fed’s aggressive rate hikes have pushed up the cost of small business loans

While the cost of debt for most large corporations has also increased, with the average BBB-rated issuer now paying about 5.7% on its corporate debt (up from 2.6% in 2022), the impact has been significantly mitigated as many of them have refinanced their debt when financing conditions were still favourable, locking in lower rates and pushing out maturities. Besides, with money market funds now yielding north of 5%, the huge cash piles sitting on the balance sheets of large companies are also earning them a decent return.

The same is true for other sources of funding.

The market for initial public offerings (IPO) remains lacklustre. While the USD 18.6 billion raised this year from IPOs on US exchanges (as of 3Q 2023) represents a significant jump from the same period last year, the proceeds are a fraction of the amounts raised during 2019-2021 (Chart 5). Furthermore, roughly three-quarters of companies that went public this year, excluding special purpose acquisition companies (SPACs), are now trading below their IPO prices, further dampening investor enthusiasm for IPOs.

Chart 5: The US IPO market remains lacklustre

Venture capital has also dried up. For many cash-strapped start-ups, the supply of capital simply isn't there, as seen from the ratio of capital demand to supply, which has skyrocketed to its highest level in over a decade for later-stage start-ups (Chart 6). Even for start-ups that have a clear path to profitability, they are increasingly exploring sales to bigger companies because acquisitions are now the most efficient way for smaller firms to bring their innovative breakthroughs to the market.

The biggest winners, then, are the established incumbents. Not only do they get to “eat up” their future rivals, they also get to secure promising technologies that could further entrench their market-leading positions.

Chart 6: US VC capital-demand-to-supply ratio hits highest level in recent memory

A quality ETF to hold for a lifetime

To conclude, the best companies to own in your portfolio are high-quality companies.

These companies are industry leaders and possess sustainable competitive advantages that will allow them to stay ahead of the competition. They also have fortress balance sheets that give them the ability to withstand financial shocks and adapt to market disruptions. Regardless of economic conditions, these companies are well-positioned to withstand the test of time and will likely do well in the long run.

As such, having stakes in high-quality companies is a prudent long-term investment strategy that will put you in a far better position than chasing short-term market movements. Rather than buying every single high-quality stock available in the market, one convenient way to get targeted exposure to high-quality companies is via the JPMorgan US Quality Factor ETF (NYSE:JQUA), a strategy that targets the highest quality businesses with high profit margins and low debt levels.

With an expense ratio of just 0.12%, JQUA is the most cost-effective ETF amongst its peers (Table 1). The ETF targets the highest-quality US large-cap companies in the Russell 1000 Index across all sectors, utilising a rules-based approach that selects stocks based on quality and profitability characteristics. The security selection methodology yields a diversified portfolio of 200-300 high-quality companies with higher profits and less debt.

The ETF’s singular focus on higher-quality, stable companies means it is a good solution for investors looking to stay invested through all types of markets, and perhaps even for a lifetime.

Table 1: Comparison of selected US quality ETFs

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in the JPMorgan US Quality Factor ETF.