Is bigger always better?
Photo: Emma Degerstedt. Source: Wikipedia
In America we like to think big: bigger companies have broader product lines; big cities offer more job opportunities and cultural events; bigger markets are more diversified. We brag about having the world’s biggest economy, the world’s biggest highway system, and several towns in the Midwest claim to have the world’s biggest ball of twine—over 8 feet across and 25 feet around.
But in business, big companies can run into problems. Big banks have regulatory issues. “Too-big-to-fail” means that once a financial corporation becomes so large that it’s embedded into most of the economy, a society can’t afford to let it fail if management makes bad decisions. That’s what we re-learned during the Financial Crisis: a bank run almost created a second Great Depression. So our biggest banks are facing special scrutiny.
Size creates sales challenges. Once you’ve saturated your home market and applied all the efficiencies you can, you need to branch out into new regions. But global diversification can create cross-cultural issues. When United Airlines opened a new hub in Hong Kong, they celebrated by handing out white carnations. But to many locals, the white flowers represented bad luck or even death. United quickly switched to red carnations, but the damage was done.
Bigger companies face bureaucratic complexity. The physical challenge of sourcing large amounts materials, building a millions of products, and delivering them to customers requires an intricate minuet of inventories, manufacturing, and finance. Everything has to be just in the right place at just the right time. A storm or a financial hiccup can disrupt the supply chain and lead to lost sales.
For these and other reasons, there’s a “size effect” in the stock market. Smaller companies tend to do better, over time, than large companies. Since 1993 the S&P Small Cap index has grown by 10.7% per year, while the S&P 500 has only returned 9.1%. Small stocks don’t outperform large stocks every year, and they tend to be more volatile. But over time, investing in small companies adds value relative to owning their larger cousins.
Small Cap vs. Large Cap. Source: Bloomberg
That’s why companies do spin-offs and divestments. Downsizing allows them to focus on their core competencies. In personnel management, we sometimes see a “Peter Principle” at work, where competent employees are promoted until they no longer perform well—they rise to the level of their incompetence. The same thing can happen to corporations: they grow until they can’t.
Henry David Thoreau observed 160 years ago: “Our life is frittered away by detail. Simplify, simplify, simplify! I say, let your affairs be as two or three, and not a hundred or a thousand.” The same might be said of companies. Sometimes the best way to grow is to shrink.
Douglas R. Tengdin, CFA
Chief Investment Officer
[tag size effect, Thoreau, Peter Principle]