Insights
There are three components of the stock market that are incredibly important to recognize: Concentration of Profits, Stock-Based Compensation, and Financial Friction.
Concentration of Profits
Each year, the top 10 U.S. publicly traded corporations retain a very large percentage of the profits from all the stocks available.
At the end of 2023, the top 10 corporations accounted for 27 percent of the market capitalization and earned 69 percent of the economic profit.
(Source: FactSet and Counterpoint Global.)
This pattern occurs annually, with the top 10 companies changing from year to year.
As of November 2024, the NYSE has 2,272 listed domestic and international companies, while the Nasdaq had a higher figure of 3,432, totaling 5,704.
Thus, a different set of 10 names captures an inordinate amount of profits each year, and money continues to concentrate among the next names down the list.
There are 11 Sectors in the Market
The sectors are: Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology (IT), Materials, Real Estate, and Utilities.
Each year, the sectors rank differently than in the previous year. This phenomenon is called sector rotation; a top-performing sector could be at the bottom the following year.
The market cycle is a pattern of price action in financial markets that tends to repeat over time.
Market cycles are characterized by periods of growth and decline and are influenced by various factors, including:
Economic trends
Real-world events
Investor sentiment
Monetary policy
Recap
Profits flow to the very top; money is always shifting in and out of different areas of the market. Most companies do not earn an average market return or do not earn a return at all and are, in fact, constantly unprofitable.
Investing is further complicated by the fact that many companies will remain unprofitable for extended periods until the market cycle briefly lifts them into profitability, after which they often collapse back into their previous state.
For the small percentage of companies that are consistently profitable, they are well-known entities, and investing in them without overpaying is a difficult needle to thread. Their above-average profits attract constant competition and create a challenging environment to defend. Technological advancements also dismantle many seemingly impervious defenses.
This illustrates the difficulty and challenge of successfully investing in the market and consistently earning an above-market return. Achieving a market return is straightforward via an extremely low-fee exchange-traded fund that tracks the market.
The Other Half of the Coin
A component of the stock market that has a profound influence on the above results is Stock-Based Compensation and Stock Buybacks.
Public companies operate very differently than private companies, and these differences significantly affect market outcomes.
Privately held companies typically have one or more owners who more often than not possess a deep understanding of their business and its associated challenges, such as competition, relationships, cost of capital, return on capital, accounting, marketing, and so much more.
On the other hand, public companies can have a vast number of shareholders. Most of these "owners" have little or no understanding of running a business. Daily, they may sell their shares at the first sign of business difficulty—real, perceived, or imagined.
As of 2020, combined active and passive funds owned only 28% of U.S. stocks, up from 26% in 2010. Pension funds, hedge funds, insurance companies, family offices, and retail investors still comprise the majority ownership of U.S. stocks, with a combined market share of 72%.
(Source: CFA Institute)
This type of ownership has allowed a system to flourish. Here’s how it works:
Each year, many (but not all) corporations provide shares (Stock-Based Compensation) to management and employees through various methods, such as stock options, stock appreciation rights, restricted stock, restricted stock units, or an employee stock purchase plan (ESPP).
As time progresses, the higher the share price rises, the greater the payout for recipients of SBC.
As companies continuously issue new ownership positions, this dilutes earnings due to the increasing number of shareholders.
As each year passes, previous SBC vests, and as long as the share price has been rising, the difference between the SBC price and the market share price allows employees to cash in their options and take profits. The company sells stock at the price of their shares when the SBC was awarded—this constitutes the profit spread for the employee.
To neutralize this, companies buy back shares at market price.
Problems arise when the amount of SBC exceeds a certain threshold. At that point, the company allocates a significant portion of its profits to SBC and spends most of its annual profits buying back stock in the market.
This creates multiple effects:
By continuously buying back shares, regardless of the share price, the company puts upward pressure on the share price, allowing SBC recipients to enjoy consistent outsized profits.
By using most of their profits to overpay for their stock instead of reinvesting in the business, paying dividends, or reducing debt, companies primarily operate to enrich management and employees.
One way to observe this behavior is to watch how companies react during economic downturns: they often cease buying back shares when stock prices are at their lowest (the optimal time to do so) and may issue large amounts of SBC when strike prices are low, facilitating extreme profit-taking by management and employees.
Under this system, who among these public company "owners" will raise their voice? Few, if any.
If a company isn’t issuing new shares for free and its share price isn’t overpriced, it is generally good policy to buy back shares, reducing the number of owners and increasing earnings per share.
An astute investor will respond well to this scenario. The market does not differentiate between this specific occurrence and share buybacks in general.
The market is greatly influenced by stock analysts, many of whom exclude SBC when creating their financial models and forecasts. One of their favorite metrics is Free Cash Flow.
Even though companies use a significant portion of their FCF to buy back shares they previously issued, analysts often strip this out of the FCF number.
When reviewing companies to invest in, be sure to examine the number of shares outstanding, the reasons for any changes, and the free cash flow; track how both flow through the years.
If a company, even one that performs well, spends the bulk of its free cash flow on buying back overpriced shares to cover new shares issued and inflate the price, it may actually be a poor investment.
Financial Friction
A significant amount of money made in the market arises from financial friction. The system is designed to incur costs with any movement; the more you do, the more it costs.
Retail investors face various trading costs, taxes, financial advisors, brokers, etc.
For most retail traders, patience is in very short supply. The same can be said for many corporations, leading to exploitation of this impatience.
For corporations, typical activities such as debt refinancing, acquisitions and divestitures, equity and bond issuances, share buybacks, management consulting, accounting, and regulatory compliance also incur costs.