Large is Good?

Superiority of Small-Cap Stocks

Gunner’s Note: Today we have some more great stuff from Satya Dev Pradhuman for you. As you might recall, Pradhuman is the Director of Small-Cap Research at Merrill Lynch and was ranked the No.1 small company analyst for the year 2000 by Institutional Investor Magazine. He has also served as a quantitative analyst focusing on small-cap and midcap equity and equity derivatives at Merrill Lynch, and has held positions in research at E.F. Hutton and Lehman Brothers.

Today, Pradhuman examines the “large is good” philosophy that dominates Wall Street today. As you’ll read, not only is this dead-wrong, but it could also cost you profits! Take a look at what Pradhuman has to say...

And if you want to check out more of Pradhuman’s ideas, check out his book here...

The Sleuth
Large Is Good?
September 18, 2006

One of the more popular arguments against the existence of a small-cap size premium regards the dominance of the large-cap franchise. It is argued that small companies are inferior to large companies and therefore make poor investments. Among the factors cited for large companies being sound investments are recent technological advances such as just-in-time inventory and e-commerce; a financial landscape that ties together global markets more closely; and fewer layers of corporate management, resulting in more efficient operations than in past decades. Bear in mind, however, that these changes should benefit all firms, both large and small. For example, improved technology increases productivity for all companies, not just for large companies. Similarly, if global markets are indeed more closely linked, this implies that smaller companies, as well as large companies, should find it easier to market their products or services overseas.

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One pivotal component of the “large is good” argument relates to the economies of scope and scale from which large firms can benefit. They can leverage these economies to take a dominant market-share position, squeeze out inefficiencies, and streamline costs to yield greater profitability. The larger a firm becomes, however, the greater the challenge to operate it efficiently. The question then becomes whether senior management can corral middle management to push through its corporate goals effectively. In an Op-Ed piece in The New York Times, David C. McCourt, Chairman of RCN Corporation, made a forceful argument that big is not necessarily better:

The most profound emotion running through the executive offices of the nation’s former telecommunications monopolies these days must be terror. The clearest example of this terror is the steady stream of megamerger announcements, which somehow feel incomplete without mentioning the word billions. . . If 100 years of business history has taught us anything, it is that Godzilla can’t marry King Kong and live happily ever after. For all the headlines these deals generate, the megamergers are unlikely to create great companies. . . Federal Express was not born of a megamerger. Neither was Microsoft, Wal-Mart or Sony. Companies that become industry leaders are marked by strong values, clear goals and better ideas. . . Moving from a destroyer to a battleship doesn’t just give you a bigger boat, it gives you a bigger boat to turn around. . . Railroads didn’t become airlines. Western Union didn’t become AT&T. Horse-drawn buggy makers didn’t go on to lead the automotive revolution. These kinds of shifts don’t happen, because companies that dominate a certain technology find it close to impossible to cannibalize their own business to embrace the changes being imposed on them. . . Unfortunately, the eyes of the terrified often see bigger as better, even when the reality dictates the opposite.

Although McCourt clearly disagrees with the “bigger is better” argument, the “large company, good investment” mantra has been partly based on the superb stock performance of large companies in the latter half of the 1990s and much of the 1980s. In The Synergy Trap, Professor Mark Sirower of New York University assails the large-is-good argument by identifying the significant number of hurdles that firms face as they attempt to become megaplayers. Ultimately, many companies overpay to grow. As a result, even if a combination makes good business sense, management still faces tremendous difficulties in generating profitable results. The hurdles for these newly formed entities are significantly higher because of the premium they typically pay to achieve so-called synergies.

Further, as noted in The Synergy Trap, the value combinations tend to be overestimated. As a result, the odds are typically against a firm’s being successful by simply acquiring size or buying other companies to become a larger force. If a deal is properly structured and priced, it is possible for even a poor business combination to yield successful results. The “large company, good investment” argument is especially appealing because one can easily follow the commentary of corporate change and can point anecdotally to the success of blue-chip stocks as evidence. But can the largest companies dominate the equity performance race over time, simply because they are “good” companies? Small-cap cycles in the past have not depended on large-cap stocks being inferior companies. The outperformance of small companies from 1991 to 1993 did not imply that large blue-chip firms such as Merck, Coca-Cola, and Microsoft were inferior businesses. Yet the secondary market handily outpaced its blue-chip brethren.

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A critical but faulty assumption behind this argument is that great companies are synonymous with great stocks. This logic is flawed because the value of a firm is based on expectations of growth. If the market has already priced-in a rosy outlook for a company, what incremental or ongoing evidence drives existing valuations higher? If all good news has already been taken into account in the price of a company, the equity component of this company quite possibly is a questionable investment.

If large companies were to dominate the equity markets because they are fundamentally “better” than small companies, size rotations would cease to exist... However, size rotations from small to large caps, and vice versa, have been a strong force in the market and are likely to continue. Simply put, a small-cap bull market is as likely to occur as a rally among blue chips.

If the logic underlying the “large companies are good companies” philosophy were sound, it is reasonable that the largest companies would likely dominate the market. However, if the largest of the large companies continued to grow in market capitalization, the corresponding valuations of these firms would likely become excessive. At some point, expectations would reach unsustainable levels and cause such favorite stocks to subsequently correct.

Whether or not market participants agree with the “large is good” hypothesis, the dedicated large-cap investor is likely to migrate to attractively valued large companies under extreme valuation conditions, such as when one segment of large companies is severely overvalued in comparison to the remainder of the market. As long as investors are opportunistic in their trading and buy companies for reasonable value, they are likely to trade out of overvalued companies, causing a rotation within their large-cap universe. This “value” rotation within the large-cap market implies a marginal shift toward smaller firms as well as cheaper stocks. The evidence clearly indicates that if a size swing occurs in the large-cap market, a concurrent rotation also occurs across the entire market. Stock prices in major markets such as the United States, the United Kingdom, Japan, and Australia, for example, consistently suggest that swings in size occurring in the large-cap market also ripple through to the secondary market. This rotation refers to the Domino Principle...

[The chart above] illustrates how rotations within the large-cap market appear to trace rotations in smaller capitalized firms. If large firms were simply better companies and therefore merited the exclusive attention of the equity market, the startling correlation between intra-small-cap and intra-large-cap cycles would not exist.

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Satya Dev Pradhuman is the Director of Small-Cap Research at Merrill Lynch and was ranked the #1 small company analyst for the year 2000 by Institutional Investor Magazine. He has also served as a quantitative analyst focusing on small-cap and midcap equity and equity derivatives at Merrill Lynch, and has held positions in research at E.F. Hutton and Lehman Brothers. Ranked in the top echelon of small-cap analysts by Institutional Investor and Reuters, Pradhuman is often sought out and has been cited in leading publications such as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, and has appeared on CNN, CNBC, and The Nightly Business Report.