The term "diminishing returns to scale" comes to mind when I think about the extent to which huge financial institutions have been wiped off the map. Their management teams, at every layer, just couldn't resist the amounts of money they made by looking the other way. The size of huge companies, like Merrill Lynch and Citibank, make it too tempting for too many people to always be thinking, "What's in this for me?" There's no incentive to waste mental bandwidth over concerns about the future of the organization. Less than 400 people brought down the 83,000 employees of Lehman Brothers. Vikram Pandit, CEO at Citibank, sold his hedge fund to the bank for $800 million and then closed it down. There goes about a billion of shareholder equity, and the man responsible is now running the bank. It's the politics of selfishness in the world of large companies.
In theory, larger companies create "returns to scale" that make them more efficient because of their size. In many cases, it's true. Starbucks eclipsed the mom-and-pop corner coffee shop industry thanks to marketing sophistication, bulk buying of coffee, and access to OPM (other people's money) through the stock and bond markets. All were attributable to a size advantage. Some industries can only function when done on a large scale, like steel, for example. I'm old enough to remember when Mao Tse-tung was encouraging Chinese citizens to make small back yard blast furnaces in an effort to up that country's steel production. It fell short of expectations.
Today, as the stock market begins to show signs of bottoming out, 401(k) participants making steady per-pay-period contributions, and others with money on the sidelines are beginning to sniff for deals. Given today's circumstances, what investment types offer greater probability for success?
As Mark Hulbert reports in the New York Times, small company value funds have been discovered over the years to yield higher rates of return than the broader stock market averages. If the last forty years is any indication, they also tend to be first out of the blocks when markets recover. Eugene Fama, the guru of efficient markets theory, identifies value stocks in general as those making up one-third of all stocks with the lowest price-to-book ratios. In other words, those whose stock prices are closest to what might be the actual value of a company if it were to be liquidated and sold for the value of the assets it owns. Companies meeting this criteria beat the overall market averages by 4.9 percent per year. The small company subset of these value stocks beat the averages by even more, 6.4 percent per year from '63 through October of this year.
I think those figures are a little optimistic. The anecdotal figures I have lived with for years have been 10 percent per year for the overall market (including reinvested dividends, and 12 percent for small cap stocks overall (which would include small cap growth as well as value.) Regardless, it is clear that small caps present more volatility and less in the way of reinvested dividends. However, this is what causes the "risk premium" or that invisible hand of economic forces that rewards people who can stomach on a more regular basis what we have all had to live through this year. They probably deserve their extra 2 to 6 percent per year.
Much of the small company gains have been concentrated in the last few months of a bear market and the first months after the market has started its ascent. Starting in 1973 and for the following ten years, small cap funds trounced the "nifty fifty" (Xerox, IBM, HP, Litton, etc) that had dominated the markets through the 60s.
One of the mechanisms brought into play with small companies is the magic moment when they reach $1 billion in value. At that point, they get within radar range of large money management pools that are too big to consider companies worth less than a billion. Hitting the billion-dollar screen lights the afterburner and opens up a new level of demand under the stock. A self-fulfilling prophesy begins to unfold.
Some would say that the "greater fool theory" just reached a point at which the fools suddenly increased in number and brought a lot more money.
Earlier this last summer, small cap funds began to "make their move" but were beaten back by the events of the financial crisis. The next time out, they may get some traction and revert to the norm, a norm which will reward any who have stayed with them through this downturn. Meanwhile, to the extent that smaller companies are attractive for financial reasons, they also represent an environment where people are naturally more accountable. If we reward that behavior with some of our investment money, statistics indicate that they will return the favor.