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.

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.

Excerpted from Small-Cap Dynamics (c)2000 by Satya Dev Pradhuman. Reprinted by arrangement with Bloomberg Press.
September 18, 2006

Large Is Good? was originally featured in the Penny Sleuth.

Some of the more compelling factors that have been cited as arguments against the existence of a size premium include: measurement error, inferior profitability comparisons, and the erratic nature of spikes in small-cap returns. Another popular but qualitative argument holds that small companies are inferior to large companies in terms of product and services, management depth, balance sheet, and similar factors. Other relevant issues investors must reconcile, before taking on a small-cap position, relate to the illiquidity of small stocks, which interferes with the ability to invest quickly.

Flaws in Performance Data

Historical data are always subject to frailties of human error. By extension, a measured effect is only as good as the database from which it is drawn. One way in which critics debunk the size premium is to claim that the data are flawed. They argue that databases tracking security prices as far back as the 1920s must contain some degree of error. Yet the services that provide such pricing data claim that they accurately capture all events that have been transacted in the equity markets. Factors such as survival bias, or databases that do not account for companies that have gone bankrupt or not “survived,” or other data hitches such as flawed data entry, certainly leave open the possibility that compelling small-cap returns have been measured less than perfectly.

Because of the robust sample size, however, it becomes difficult to argue that errors in the data, which are clearly drawn at random, consistently bias the smaller stock returns. The sizable universe of companies makes it more likely that the measured returns over the long term are closer to the realized returns.

Another issue that has surfaced relates to the definition of small stocks. According to this argument, as laid out by Bill Fouse, small stocks have generated excess returns in the past because large companies were accidentally included in the sample of small companies. In the initial studies on size, size groups were reconstituted over five-year periods, which meant the sample size of the small-cap index remained unchanged for five years. As a result, some of the more successful small-cap ideas could have migrated to the large-cap universe but were mistakenly credited to the small-cap universe. Although this argument has some merit, the lengthy five-year holding period would also be likely to cover collapsing secondary stocks that small-cap investors would be unlikely to hold. These stocks, which would be incorrectly credited to the small-cap index, would detract from small-cap performance measures. Accordingly, it might be more appropriate to assign weakening issues to a group outside the small-cap universe. For instance, faltering secondary stocks that are losing market value might be more appropriately assigned to a segment of microcap stocks. Even though the upward migration of shares can produce an upward bias in small-cap benchmarks, downward migrations can likewise create a downward bias in returns. Although investors need to examine all benchmark results with a critical eye, a migration bias may be less relevant than other issues. Because the markets are fluid, there are always likely to be migration effects, whether upward or downward. Over the long term, these effects are likely to cancel each other out and have little impact on any potential return bias.

To determine the significance of the migration effect, the holding periods of a small-cap benchmark could be shortened-for example, from five years to four years. The benchmark results could then be analyzed to determine whether they are significantly different when the rebalancing frequency is cut down to three years, two years, or one year. In one simulation, several identical small-cap portfolios were created to vary only by the length of the holding periods. The portfolio results were nearly identical. Based on this study, there seems to be little evidence that the performance of a small-stock index calculated over a five-year holding period varies greatly from that of an index with a four-year holding period. In fact, the results appear to be fairly uniform across holding periods.

The significant number of companies that comprise the small-cap market accounts for the stark similarities among small-cap benchmarks reconstituted across holding periods. In other words, once a benchmark is constructed with several hundred companies, as most small-cap benchmarks are, the averages are more likely to converge, reflecting quite similar results. Although index turnover can appear significant, the net performance results do not necessarily vary because of the tendency for a broad core of small-cap names to remain in an index over lengthy periods.

Suspect Small-Cap Cycles

The size premium has also been questioned in relation to performance cycles. In an argument posed by Jeremy Siegel, a Wharton School professor and noted author, the degree to which small stocks outperformed large stocks in the 1970s was unusually strong and possibly suspect. According to this thinking, if the 1974-83 period were removed from the long-run performance analysis, the remaining data would yield a large-cap premium.

That ten-year-period appears to have represented a bonanza for small-stock investing. Figure 6.2 presents the performance of the Ibbotson Small Stocks Index versus that of the Standard & Poor’s 500. Note that the long-run data from 1926 to 1999 indicate that a dollar invested in small-cap stocks would be worth approximately $6,545, compared to approximately $2,842 for large stocks over the same time frame. If the years 1975 through 1984 were removed, however, large caps would have generated $2,004 and outpaced small stocks, which would have gained only $1,202 over this period.3 The period in question represents an unusual time, one of oil shocks and devastating inflation. Although it might seem reasonable to remove an anomalous subset of returns, this analysis neglects the possibility that unusual events have occurred in practically every decade. If the 1975-84 period were removed from the analysis, this elimination would also erase a bear market for large caps that occurred during the first half of this time frame. This approach inadvertently assumes that investors can adeptly time a large-cap bear market. It turns out that besides being a period in which small-cap returns were stellar, the 1970s also marked a bear market for large-cap returns.

Figure 6.2: Small-cap cycles in good and bad times

Likewise, most of the subsequent period from 1984 to 1991 should be removed from analysis because large stocks exhibited unusually high returns during those years. In this time of severe disinflation long-term government bond yields fell from the mid-teens to roughly 5 percent over a 10-year period. Investors are unlikely to face such a significant period of disinflation within the foreseeable future. If the 1984-91 period were removed from the analysis, the long-run performance results, not surprisingly, would show that small stocks outperformed large. In fact, as presented in Figure 6.2, the margin of small-cap outperformance would be even greater than that of the long-run time series data. As this discussion demonstrates, selective measurements can cloud any analysis, including an analysis of the small-cap premium.

Excerpted from Small-Cap Dynamics (c)2000 by Satya Dev Pradhuman. Reprinted by arrangement with Bloomberg Press.
September 07, 2006

Small Caps Outperform Large: Fact or Fiction? was originally featured in the Penny Sleuth.