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Disturbing New Facts About American Capitalism

The Wall Street Journal. logo The Wall Street Journal. 3/3/2017 Jason Zweig

File photo of shoppers at the Tiffany & Co. store in Las Vegas, Nevada© Ethan Miller/Getty Images File photo of shoppers at the Tiffany & Co. store in Las Vegas, Nevada “Let your winners run” is one of the oldest adages in investing. One of the newest ideas is that the winners may be running away with everything.

Modern capitalism is built on the idea that as companies get big, they become fat and happy, opening themselves up to lean and hungry competitors who can underprice and overtake them. That cycle of creative destruction may be changing in ways that help explain the seemingly unstoppable rise of the stock market.

New research by economists Gustavo Grullon of Rice University, Yelena Larkin of York University and Roni Michaely of Cornell University argues that U.S. companies are moving toward a winner-take-all system in which giants get stronger, not weaker, as they grow.

That’s the latest among several recent studies by economists working independently, all arriving at similar findings: A few “superstar firms” have grown to dominate their industries, crowding out competitors and controlling markets to a degree not seen in many decades.

Let’s look beyond such obvious winner-take-all examples as Apple or Alphabet , the parent of Google.

Consider real-estate services. In 1997, according to Profs. Grullon, Larkin and Michaely, that sector had 42 publicly traded companies; the four largest generated 49% of the group’s total revenues. By 2014, only 20 public firms were left, and the top four -- CBRE Group , Jones Lang LaSalle , Realogy Holdings Corp. and Wyndham Worldwide Corp. -- commanded 78% of the group’s combined revenues.

Or look at supermarkets. In 1997, there were 36 publicly traded companies in that industry, with the top four accounting for more than half of their total sales. By 2014, only 11 were left. The top four -- Kroger Co., Supervalu , Whole Foods Market and Roundy’s (since acquired by Kroger) -- held 89% of the pie.

The U.S. had more than 7,000 public companies 20 years ago, the professors say; nowadays, fewer than 4,000.

The winners are also grabbing most of the profits, according to the Leuthold Group, an investment-research and asset-management firm in Minneapolis.

At the end of 1996, the 25 companies in the S&P 500 with the highest net profit margins -- income as a percentage of revenues -- earned a median of just under 21 cents on every dollar of sales. Last year, the top 25 such companies earned a median of 39 cents on the dollar.

Two decades ago, the median net margin among all S&P 500 members was 6.7%. By the end of 2016, that had increased to 9.7%.

So while companies as a whole grew more profitable over the past 20 years, the winners become vastly more profitable -- nearly doubling the gains they got on each dollar of sales.

Among the 25 companies with the highest margins last year were eBay , Altria Group , Baxter International , Gilead Sciences , Corning , Visa , Mastercard , Facebook , Amgen and Biogen .

“I’m disappointed in capitalism,” jokes Doug Ramsey, Leuthold’s chief investment officer. “It seems that the big ones are just slowly pulling away.”

Why might it be easier now for winners to take all? Prof. Michaely suggests two theories. Declining enforcement of antitrust rules has led to bigger mergers, less competition and higher profits. The other is technology. “If you want to compete with Google or Amazon,” he says, “you’ll have to invest not just billions, but tens of billions of dollars.”

He and his colleagues have found that if you had invested in industries where the top companies were growing more dominant, while betting against sectors whose top firms were becoming weaker, you would have outperformed the overall stock market by an average of roughly nine percentage points annually between 2001 and 2014.

To do that, you would count the public companies in a given industry each year and use the sales figures from their annual reports to calculate what’s known as a Herfindahl-Hirschman Index.

If the number of companies is trending down, and the HHI is going up, then the winners are taking all -- and you should buy.

Maybe that’s what many stock investors have been doing lately, even if they’re going on their gut rather than statistical evidence. And with the winners having driven weaker companies out of business, too much money is chasing too few stocks.

Still, history offers a warning. Many times in the past, winners have taken all -- but seldom for long.

Perhaps the laws of creative destruction finally have been repealed once and for all. But sooner or later, capitalism has always been able to turn yesterday’s unstoppable winners into the also-rans of today and tomorrow.

You could look it up -- preferably on a BlackBerry , if you can find someone who still uses one.

Write to Jason Zweig at intelligentinvestor@wsj.com, and follow him on Twitter at @jasonzweigwsj.

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