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Companies Used to Have Moats Around Their Products. Now They Have Kill Zones.
Investors must catch up, PGIM urges.
Allocators and asset managers must rethink how they invest in companies that hardly resemble the blue chips of the last half century, according to PGIM’s annual study on megatrends released Wednesday.
The company of the future — whether public or private — will fall into three general categories: so-called “weightless firms” with capital-light models and mostly intangible assets like data, software, and brands; “superstar firms” that dominate economic sectors beyond technology; and “purpose-driven” firms with environmental, social, and governance (ESG) or impact mandates.
Taimur Hyat, chief operating officer of PGIM, expects the first category — weightless firms — to have far reaching consequences for investors because of the way they use capital.
At present, 85 percent of the value of S&P 500 stocks are in intangible assets, PGIM calculated.
“Investors should seriously consider how they balance their allocations between private and public companies,” said Hyat in an interview. Companies are staying private longer for a number of reasons, but he said capital intensity is a big piece of the rationale behind founders’ desire to stay out of public markets.
“For capital intensive-companies that need to build factories, say, it makes sense to tap the public markets,” said Hyat.
Weightless companies don’t need as much capital to build their product or service, and take longer to become successful. Together, those factors make a case for staying private. “There’s a longer path to profitability. You don’t want the impatience of capital markets,” he added.
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PGIM expects weightless firms to employ far fewer people because of automation and a switch to the Uber model of offerings gigs rather than full-time jobs. According to the report, which looks at the investment implications of transformative new corporate models, these companies also use office space far more efficiently than their predecessors. That is forcing changes on the commercial real estate market.
Investors have a near-term opportunity to invest in the public and private debt of companies based on misunderstandings about intangible assets, PGIM argued. Credit ratings agencies, which have failed to keep up with changes in corporate models, still emphasize the importance of tangible assets in their evaluation of credit risk. But cash flows of firms of the future may be just as stable, especially given their limited capex requirements and variable costs.
“That’s an arbitrage opportunity for both public and private debt,” said Hyat.
PGIM’s report also documents the importance of the superstar firm on economies and investments. PGIM describes superstars as those that have leveraged technology, proprietary data, and networks to become virtually unassailable. In 1975, according to PGIM, 50 percent of the earnings of U.S. public companies came from 109 firms. Currently, 50 percent comes from 30 firms.
“The winner-takes-all model is extremely robust. Industry concentration has been rising, and it’s well beyond technology, including manufacturing and energy,” Hyat said.
Instead of moats protecting their competitive advantages, they have kill zones. “The superstar with a technology or product advantage can effectively protect their network and tech edge by creating a kill zone around their expertise,” he explained. This includes acquiring smaller firms’ research and intellectual property to strip them of their ability to compete or acquire the firm outright before it becomes a threat.
Superstar firms have already had a big impact on venture capital and PGIM is advising investors to be cautious about venture.
“This is because a growing number of startups are bought out prematurely by dominant superstar firms who want to shut down challenger products or assimilate new capabilities that might provide a competitive challenge in the future,” according to the report. “This has discouraged VC financing in the kill zone where the prospects of generating 10x or 20x growth returns are stymied by the increasing probability of a speedy acquisition by monopolistic incumbents.”
PGIM pointed to the decline of annual first financings for startups in internet software, social media, and other categories as evidence of the trend.
“Investors still committed to VC should consider seeking investments that don’t directly compete with large incumbents, notably in areas with low industry concentration and the absence of a dominant superstar,” according to the report.
“Alternatively, investors looking to capture the growth opportunities typically found in VC will need to look toward larger, scaled companies that are effective in building or acquiring new technologies, products and services,” argued PGIM.