Super-Size Me?

How big is too big?

Woodblock of a sumo wrestler in Japan. Public Domain Source: Wikipedia

80 years ago the Nobel Prize-winning economist Ronald Coase set out to explain why people organize themselves into businesses, firms, and corporations rather than just freely trade goods and services amongst one another. If Adam Smith’s “invisible hand” is so efficient, why don’t we all organize ourselves independently?

The economic answer has to do with efficiency. It’s cheaper to build a company around one product or service and aggregate the inputs and outputs needed to get the product to market, rather than everyone negotiating every little detail with everyone else. With a large and complex system like an automobile, there are millions of parts and systems, each of which must be designed and built to precise specifications. It would be too inefficient for the billions of transfers to be negotiated independently.

Transactions costs can be lowered dramatically by bringing them into a single firm. When this works, it works beautifully: an engaged workforce creates and produces something the sales-force can market effectively, gathering feedback from customers as they go, funneling this to an R&D group that solves problems imaginatively.

But nothing fails like success. Small firms that innovate effectively grow into behemoths that become caricatures of themselves: cubicle farms straight out of “Dilbert.” That’s partly why there’s investor skepticism around giant companies: no tree grows straight to heaven. Mega-firms create mega-administrations and bureaucratic nonsense: Soviet-style “republics” where meeting the plan and planning the meetings are far more important than innovation and customer service.

Efficiency then leads to inefficiency, creating opportunities for new competitors to enter a market and provide better products at cheaper prices. That’s why small cap stocks outperform large caps over the long run. The firms grow faster, but they’re also riskier. Money isn’t wasted on paperwork and corporate politics, but there isn’t as much of a safety net if things go wrong. The higher risk is the price investors pay for the extra return.

Stocks, Bonds, Bills and Inflation 1926-2016. Source: New York Life

Someone once asked Abe Lincoln how long a man’s legs should be. His answer was simple: long enough to reach the ground. In the same way, we might ask how large a company should be. The answer is equally simple: large enough to be efficient—and no larger.

Douglas R. Tengdin, CFA

Chief Investment Officer

Charter Trust Company

By | 2017-07-17T12:21:31+00:00 January 20th, 2017|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. –
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