The Gap Between Large and Small Companies Is Growing. Why?
Popular belief amongst investors is that large companies tend to grow slower, especially given that the size tends to have drag on their agility when it comes to innovation. We often are asked if we aren’t worried about our Consistent Compounders portfolio companies which are already well known market leaders in their respective sectors. In our December 2019 newsletter, we noted that in a third world economy like India, the growth runway for most products and services is still very long and hence companies that can sustain their competitive advantages can still deliver healthy long term growth rates. Separately, we have also talked about the consolidation of the Indian economy into a handful of companies in each sector. However, this shouldn’t be construed as large caps being superior to small caps as dominant market leaders in niche industries can still be found among small caps. In this HBR paper, the authors who are professors at Tuck, Stern and Calgary, highlight how larger companies have indeed increased their gap over small companies not just in terms of size but also in terms of their profitabilities. In a way they link this to the larger companies’ superior ability to invest in technology, an increasing source of competitive advantage in most industries and amortise the R&D spend across a larger base.
“Contrary to the popular notion, we find that large corporations are more and more likely to maintain their dominant positions, while small corporations are less and less likely to become big and profitable. And part of the reason for this growing corporate divide between big and small firms is the growing R&D expenditures of large firms. Our results support Lou Gerstner’s thesis that the elephants are not basking in their past glory, but can indeed dance and are even becoming nimbler.
… The performance gap between the large and small increases too. The difference in median return on operating assets was 15% in the 1990s, but has recently doubled to 30-35% — an enormous gap in profitability of operating assets. Inspecting the two groups separately clarifies that the large companies are geting more profitable, whereas the small ones suffer from chronic unprofitability. In fact, both the median return on operating assets and the median profit margin of the small companies turned negative during 2015-2017.
When we examine the main driver of enterprise performance and growth – the rate of investment in tangible and intangible (R&D, brands, technology, human resources, etc.) assets – we find a dramatic increase in the gap between how much large and small companies invest in intangibles. The chart below shows, for example, that the difference between the mean annual R&D spending of large and small companies grew from less than $20 million in the 1980s to almost $120 million in 2017 (inflation adjusted to 1981 dollars). On average, a large company spent $330 million on R&D in 2017, while the average small company spent a paltry $6 million – obviously insufficient to keep pace with a large competitor, except through a fortuitous discovery. The decreasing productivity of R&D investments makes matters worse for small companies”