The End of Winner-Takes-All

Complexity economics shows that, in a zero discount rate world, companies rationally pursue market domination—Today’s high discount rates mark the end of winner-takes-all economics—This new paradigm has implications for passive, US, and growth investing.

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THE END OF WINNER-TAKES-ALL

In 1994, a new economic model was presented by W. Brian Arthur to explore rational pricing actions in markets with a winner-takes-all dynamic.[1] As we enter a new era of rising interest rates we have an opportunity to look at this theory to educate ourselves on where the markets may be headed.

THE THEORY

Arthur’s model explores the dynamics between market share, pricing strategy, and discount rates. The graph below summarizes the findings of the model.

In a low discount rate environment, where current profits and cash flow are less relevant, economic players are incentivized to pursue a winner-takes-all strategy. This is seen in the forefront of the chart where price is dropped to zero in an effort for one player to achieve a monopolistic share.

This dynamic accurately reflects yesterday’s low discount rate world. Businesses pursued highly aggressive customer acquisition strategies to monopolize markets. The model shows this to be rational with discount rates approaching zero.

Today, in a non-zero discount world, winner-takes-all economics are no longer rational. The background of the graph, a high discount rate environment, shows a gentle curve around market share and price. Economic players do not drop their prices to zero to capture share. Correspondingly, businesses can be profitable at all levels of market share, reducing the propensity for markets to become highly concentrated.

In retrospect, this model was highly accurate in predicting rising concentration of market share, and investment returns, in a declining discount rate world. Importantly, the model shows that discount rates are the lynchpin to this concentration. Today we know discount rates have increased. What are the model’s implications?

THE END OF PASSIVE-TAKES-ALL: BUY ACTIVE MANAGERS

Passive indexes own the largest stocks in the largest weights. In a declining discount rate world, where winner-takes-all economics are in play, the largest companies – past winners – continue to win. This dynamic has driven the outstanding returns of passive indexes over the last decade.

The Megacap-8 have outperformed the rest of the S&P by over 6x over the past decade.[2] Active managers without a full weight of this cohort were destined to underperform.

Arthur’s model suggests that this dynamic may be coming to an end, with rising discount rates as the catalyst. In this situation, passive indexes will be exposed, holding the largest weights of the businesses most at risk of share loss. The largest, most dominant players that drove historical returns now have the most to lose.

 

A RETURN TO DIVERSIFICATION: BUY INTERNATIONAL & EMERGING MARKETS

Driven by the global success of the Megacap-8, the US has dominated global equity returns. From 2010-2022, the US was the only major market to beat a global index.[3] 

The model supports this dynamic. US-based businesses aggressively leveraged cheap capital to dominate global markets. As this winner-takes-all dynamic fades, an overweighting to US equities is a key risk for allocators.

THE END OF DISRUPTION: RETURN TO VALUE INVESTING

Winner-takes-all environments lend themselves to disruption. In a low discount rate environment, “old world” businesses are assaulted by well-funded ventures.

It is certainly uncomfortable to be an underfunded incumbent attempting to fend off hard-charging startups in a low discount rate environment – just ask any taxi driver, car manufacturer, or energy producer.

The past decade has trained investors that disruption is real, happens often and quickly, and offers enormous investment returns. But were we witnessing disruption (i.e., a drastic improvement of consumer living standards) or just a winner-takes-all share grab? 

True disruption may be hard to come by in the future. The assault on old world businesses is likely to slow as new entrants are more disciplined on spending. The combination of declining competitive intensity and attractive valuations for out-of-favor value investments bodes well for future returns.

THEORY TO REALITY

Our observations predict a reversal of the last decade's economic trends. But “reversion to the mean” is a classic value investor mistake. In this case, though, we have an economic model, and more importantly, a clear catalyst (rising discount rates), that foreshadows a change in market dynamics.

In addition, as long-term investors, we are excited to benefit from this insight for the next decade. While the rise in interest rates has instigated a change in economic incentives, nothing about the model suggests market share will adjust instantaneously. In fact, the process will take years to play out as economic players review their pricing strategies and consumers shift their preferences in response.

Finally, we’d note that these inflection points are rare in history – discount rates have been declining for 40 years! Few investors in today’s market were even alive to experience a world of rising discount rates. If we are seeing a reversal of winner-takes-all dynamics, there is a clear opportunity for allocators and investors to position themselves for success for the next era of investing by implementing contrarian views.

[1] W. Brian Arthur: “Strategic Pricing in Markets with Increasing Returns.”

[2] Yardeni Research (https://yardeni.com/charts/megacap-8/)

[3] Morningstar (https://www.morningstar.com/funds/why-us-equities-have-beaten-international-equities-since-2010)