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Most value investors are painfully aware that the U.S. equity market has not been kind to their preferred investment approach for the past 10 years.

Looking at the Russell 1000 as a proxy for U.S. big cap stocks, the growth sub-index enjoyed an annualized return of 15.2 per cent for the 10 years ended Dec. 31. The value sub-index, in contrast, lagged by almost four percentage points with a return of 11.8 per cent over the same period.

The situation was just as clear cut if your focus was small-cap stocks: The Russell 2000 small-cap index annual returns were 13 per cent for growth and 10.6 per cent for value stocks.

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The reaction of the value-investing community has been to assume that this preference for big cap and growth is some sort of fashion statement, which will reverse course eventually as part of a mean-reverting process.

As a long-time small-cap value investor, I hope they are correct. But, after reading The Great Reversal: How America Gave Up on Free Markets by New York University finance professor Thomas Philippon, I am persuaded that there are structural reasons why big cap growth stocks dominated U.S. equity returns over the past decade. Until this environment changes, small-cap and value stocks may remain on the outside looking in.

Simply stated, the author claims that many industries in the United States have become more concentrated, as measured by market share of the major corporate players, in recent years. Sometimes this is beneficial for the economy as a whole. What he calls the “rise of the Superstar firms” results in new products or services, lower prices for existing goods or a better consumer-facing experience. As a result of this type of concentration, GDP growth is boosted, jobs are created and price competition keeps inflation low. Think Walmart during its early growth trajectory.

Once companies reach dominant market share, they can continue on this aggressive growth trajectory to fight off current or potential competitors, or they can redirect corporate expenditures away from R&D toward protecting their incumbency. This means spending money to buy up fledgling competitors before they become a threat, erecting barriers to competition through regulation or licences and lobbying to protect the status quo.

How can we tell when there has been a switch from beneficial concentration to the defensive version? Prof. Philippon suggests that we look at how corporations allocate their operating surplus funds. In the period 1962-2001, 20 per cent of this cash flow was reinvested in net fixed capital formation – essentially plowed back into the business. From 2002 to 2015, this percentage has dropped to average only 10 per cent of the surplus funds.

There are multiple reasons why a company may choose to reinvest less into the business: The market is growing more slowly, more money is being spent on intangibles that do not show up in capital expenditures, productivity improvements require less investment to sustain the growth, or barriers to competition reduce the need to innovate.

We cannot know the individual decision process at each company, but Prof. Philippon again suggests that we follow the money to see how it is being spent. His graphs show that the number of merger and acquisition deals has increased dramatically in the past 20 years, while at the same time there has been a sharp decline in the number of listed companies. While this concentration has been taking place at the top, the arrival of new entrants (companies less than five years old) has also declined steadily, which further reduces the dynamism of the U.S. economy. In addition, dividend payout ratios are up, a tidal wave of cash directed toward share buybacks and little of this is adding to productive capacity in the economy.

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None of this explains why these dominant firms should be rewarded by superior performance in the stock market, but the author also identifies a significant increase in after-tax corporate profit margins in the past 20 years. This is a result of a small increase in pretax margins and a major drop in the average tax rate from about 50 per cent to closer to 20 per cent currently. We see the same picture with the share of GDP made up from corporate profits: For many years it was stable in the 6-per-cent to 7-per-cent range. Now corporate profits make up 10 per cent of GDP.

With this combination of increasing industry-level concentration, higher after-tax profits and free cash flow directed toward rewarding the owners of the assets, it is no surprise that big cap stocks were the preferred choice of investors over the past 10 years. And, once in place, it is difficult to envisage a scenario that will reverse this momentum.

Prof. Philippon’s thesis is that the U.S. in the late nineties was an economy with dynamism, low barriers to entry and industry concentration primarily in the beneficial category. Since the turn of the century, the dominant players have moved to a more defensive posture to protect their incumbency, which is great for the owners, but not so good for the consumer or the smaller players in the economy.

He illustrates his point with reference to the cellphone market and domestic airline fares. In 1999, when he arrived in the U.S. (from France), he found that both of these sectors offered price points that were dramatically cheaper than those available in Europe. Now the situation has reversed – which explains the title of the book – and European industry is in many ways less regulated than that of the U.S.

Investors are often urged to read articles and books that challenge our entrenched beliefs. The Great Reversal certainly falls into this category. A 300-page book about industry concentration and antitrust regulations does not sound very readable, but the author presents his case well, with humour and lots of graphs. It really is a delight to read.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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