Does market power deliver above-average rewards to investors?

by Finploris
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“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

Warren Buffett, Fortune Magazine, November 22, 1999

The challenge is that the sustainable moat is a qualitative metric that is difficult to evaluate in most instances. In place of analyzing a company’s moat, we can evaluate more concretely a company’s market power. By identifying more profitable firms with few competitors, investors can benefit from higher cash flow stability and a lower risk of concurrently investing in close rivals. Companies with market power face fewer product market threats, as supposed by their lower average product market fluidity.

Companies with less product competition show higher valuations, lower liquidity, tent to be older and are analyzed by fewer analysts. The firms with market power are in general small- to medium-sized firms which operate in narrow market niches where a few highly specialized companies compete with each other. Because only a few analysts follow these small market niches, company news in such markets tend to spread slowly. However, stocks with little market power generate a similar return as compared to firms with market power. The reason for this is that market power is not stable. Nevertheless, firms that operate in less efficient markets with fewer competitors have the ability to gain a larger market share and enhance their profit margins by increasing their market power.

Source: Jaspersen, Stefan, Mutual Fund Bets on Market Power (February 10, 2021)

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