One of the more vexing problems I’ve spent more time thinking about recently, is how most of the attractive businesses with phenomenal business models are already quite large. In fact, many of the businesses I think worth owning are large or mega-caps. However, despite their size, many of these companies are outgrowing smaller peers and with business models that appear much more likely to sustain during tougher times. Despite my conviction based on bottoms-up first principles analyses, it’s also clear that historically smaller companies have been able to do much better than larger peers.
While considering this problem more deeply, I’ve come to the conclusion that we are likely just at the beginning of a multi-decade transition in the global economy that will further concentrate commercial and financial power at the very top. There will undoubtedly be pockets of small cap outperformers, but many of the factors that helped smaller peers outperform larger peers over the long term seem to be eroding. In fact, large companies historically faced negative feedback loops that would act as mean-reversion forces, but many of those negative feedback loops are no longer as effective.
One of these negative feedback loops is organizational complexity. Prior to the information / digital revolution, large companies were mostly operating in retail, industrial, commodity, and manufacturing sectors. These are sectors that generally require large labor forces and heavy organizational structures to control sprawling assets nationally and internationally. However, very, very few organizations are able to remain nimble at size and hence size has historically been somewhat of a negative feedback loop. The larger a corporation becomes, the harder it is to get larger.
Although this negative feedback loop continues to be an issue, many of the largest companies globally are labor-lite. The information / digital revolution has created a class of companies that are able to achieve enormous scale without maintaining and managing an enormous workforce. For example, Google and Facebook have just tens of thousands of employees. Visa, a $350 billion market cap company, has just several thousands.
Today these labor-lite structures are still confined to just several industries, but is there any question that every industry and sector is / will need to undergo an information / digital transformation in the coming years?
Secondly, offsetting the size disadvantage for large companies is a capital advantage. Usually as a company gets larger, it becomes easier to raise capital from banks and from capital markets. This advantage was temporarily minimized as the US (and many parts of the world due to rate coordination globally) went through two periods of prolonged falling interest rates – once following end of World War 2 and a second time beginning in the early 80s as Volker successfully brought inflation under control by bringing rates into the double digits, setting the stage for a multi-decade rate reduction cycle. As a result, smaller companies benefited from a tailwind from a capital perspective while large companies were hobbled from an organizational complexity perspective for much of the 20th century.
But over the last 10 years the dynamics around capital have also completely changed. Interest rates hit zero on the short end. Interest rates no longer have room to fall. More important than the level of rates is the direction of rates / debt service. With declining interest rates, profitability improves and cost of debt declines over time, which has likely been a large tailwind for smaller companies (more than for large companies because smaller companies tend to be more capital constrained). Without falling interest rates, that tailwind is now gone.
In addition, near-zero interest rates have likely created a third long-term complication for smaller companies – the cost of capital is likely now lower than the cost of labor (and cost of labor is actually rising globally). Smaller companies generally have greater reliance on labor over capital (due to more limited means of accessing capital). While I am positioning this observation as purely an issue for smaller companies vs larger companies, I’m not certain society has fully understood the implications of a world where the cost of capital is lower than the cost of labor for an extended period of time. Our central banks speak of supporting labor markets through monetary easing, but perhaps there’s a scenario where it works out quite differently than expected in the long run.
Though I have only referred to capital as one concept above, there are really two types of capital – physical capital (machines) and financial capital. What’s interesting is that many labor-lite companies are also quite capital (machinery)-lite. I think western economies have been transitioning towards capital (machinery)-lite environment for a while, but the last 10 years appear to be the start of something new – a transition towards true capital-lite economy. The likes of Apple, Google, Facebook, etc not only do not require much labor or physical assets, they also don’t require much financial capital at all. Oases in the dessert. Something from nothing. And very large to boot.
I don’t know how this story ends or where we go from here, but the environment favors the largest companies. I’m betting on big.