The bigger the big business

The bigger the big business... the greater the risk to investors

29 Nov 2019

Ben Kumar, Investment Strategist

How to get rich

It’s hard to become a billionaire investor. It took Warren Buffet 25 years to move from being a millionaire to a billionaire. Jeff Bezos and Mark Zuckerberg took two years. By the time a company goes public, its most exciting, ferocious growth phase is usually over. It’s the getting in early that makes founders into billionaires.

Founding a successful public company has always been a great way to get rich. It worked for John D. Rockefeller (Standard Oil) and Henry Ford in the late 1800’s, and worked over a century later for Bill Gates and Jeff Bezos. In late 2019, Microsoft and Amazon were the two largest public companies in the world. Bill and Jeff were each worth over $100 billion. Most of that wealth was still tied up in their companies.

If you’ve bought Microsoft or Amazon shares over the last few years, you’re probably quite happy. But you probably aren’t a billionaire. Outside investors arrive late to the party. And they end up staying the longest – often far too long.

The bigger a company gets, the more money investors throw at it. This is partly due to the way that stock markets work; the larger a company is, the greater its allocation in passive investment benchmarks. So index funds buy, buy and buy as its price rises.

Fear and greed also play a part. Investors tend to like established stories; big companies with well-known brands and billionaire CEO’s. These names are safe, familiar and comforting. Investors cluster in such ‘blue chips’, hoping they’ll make everybody rich. Again and again, this proves not to be the case.

In September 2000, for example, General Electric was the biggest company in the world, worth more than half a trillion dollars. Nearly two decades later, the business is worth just $90 billion – down 85%. In 2018, General Electric was dropped from the Dow Jones Industrial stock index. After 100 years, it was no longer seen as a representative enough part of the US economy, or an important company in the stock market.

This story has been repeated throughout history: US Steel in the 1900’s; General Motors in the 1950’s; IBM in the 1980’s; Exxon Mobil in the mid-2000’s. All had a period of incredible growth, followed by a long fall from the peak.

The capitalist system doesn’t necessarily reward success in the way we might think. Quite the opposite – it tends to punish companies that become too successful.

Too big to succeed

Why don’t the world’s biggest firms stay the biggest forever? There are many reasons. Most notably, successful companies find themselves under fire from a number of different angles.

First, there is competition. Large established peers create copycat products and take a chunk of market share. Legal battles often ensue. Think about Apple and Samsung during the early days of smartphones.

Meanwhile, nimbler competitors take chunks out of the empire. Even mighty Amazon doesn’t totally dominate online shopping. Companies like Boohoo and Asos have made online fashion their territory, while AO.com takes aim at the electric goods sector.

And big businesses are never as stable as they might seem. Along come new firms that change the game and make their products obsolete. Microsoft started out as the scrappy young pretender to IBM. Tesla is doing something very similar to the petrol-car industry.

Then there’s regulation. Big businesses come into conflict with governments – and usually lose. Many global banks found this out in 2008. Uber is finding this out today as it expands into cities across the world, fighting regulatory battles every inch of the way.

Finally, there are consumers. People are fickle. They love a product or service until it lets them down, and then they never buy it again. Sometimes they actively campaign against it. Brand loyalty can seem indestructible – but in many cases, money talks. Offer someone something cheaper, and their loyalty can vanish. The UK’s big supermarkets like Tesco and Sainsbury have found that out the hard way, as customers abandon them for Lidl and Aldi.

Capitalism creates growth and wealth on a huge scale. But people forget that it does so because every part of the system is replaceable. If a better idea comes along, the old one can get ditched. Look at Kodak. Or Nokia. Or Yahoo (you’ll probably have to Google it). Efficient markets can be cruel.

Investment implications

The capitalist free market system is harsh. The bigger big companies are, the lower they fall. A number of papers from Research Affiliates have dug into the data, and the numbers are stark. They find that in the US, the largest company in a sector in any year tends to underperform that sector by around -4% a year … for the next decade. In the rest of the world, the underperformance is even higher – closer to -7% behind per year.¹

Let’s bring the numbers home. Let’s assume that you followed a simple investment strategy from the year 1981: start with $100 and buy and hold the largest company in the world for successive 12-month periods. By 2011, after 30 years, your $100 would have fallen to $55. Had you simply invested in the global equity index instead, your $100 would have been worth $1600.¹

If you’re a wannabe billionaire, then concentration of all kinds is necessary. You need to have your good idea, and then focus your energy and resources into bringing it to fruition. Invest your all in it, and if you’re really, really lucky, you’ll join Bill and Jeff.

But for those of us with less lofty investing goals, concentration is dangerous. It’s good to be cautious about the large companies (or indeed markets) that have performed well most recently. Competitors are already eyeing up tasty parts of the winning empires, and nobody has a monopoly on innovation – not even Apple.

Instead, investors should favour diversification. Diversified portfolios invest in the market system as a whole. You own the established industry leaders, but also their challengers, and the challengers behind them. You own countries that are on the rise, and ones that are starting to slow down. You have some assets that are there for the bad times, as well as for the best times.

You won’t get rich quick. But you’re unlikely to lose your money quickly either.

Source: ¹Journal of Indicies

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