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