In my role as chief research officer for the Buckingham Family of Financial Services, I receive many questions from investors and advisors alike, asking me to address concerns they have that originate from articles they have read or statements they hear on the financial media. I thought it worth sharing my response to the questions I received about an August 2019 study published by the Harvard Business Review (HBR), with the same title as this article.
The authors, Vijay Govindarajan, Baruch Lev, Anup Srivastava, and Luminita Enache, concluded 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.” They noted: “From the mid-1990s, the size difference between the large and small increased continuously and rapidly, except for during the recession years of 2008-2009.” They observed that the large are getting bigger while the small tend to stagnate.
One explanation they offered is that there is a growing corporate divide between big and small firms in terms of R&D expenditures, with large firms spending much more. Another explanation for the widening valuation gap is that “the difference in median return on operating assets was 15% in the 1990s, but has recently doubled to 30-35%—an enormous gap in the profitability of operating assets.” A third explanation is that “it becomes harder for small companies to ‘escape’ their class.” On the other hand, the percentage of large companies remaining in that asset class actually increased.
The authors concluded:
The investment and growth opportunity set of small companies is shrinking, and their nimbleness and grit is increasingly under pressure. In contrast, the large companies are thriving, investing in innovation and intangible assets at an increasing pace, and seem better prepared to weather challenges from small companies than portrayed in literature.
Before you jump to the conclusion that you should avoid small stocks, which is what some investors were doing, let’s take a closer look at the explanations. We’re going to take a closer look at each of these claims, beginning by examining the claim that it’s getting harder for small stocks to grow and migrate into a large stock.
Dimensional Fund Advisors (DFA) has data on size migration from June 1963 through June 2018 (the original HBR article covered the period 1980 through 2017). In reviewing the DFA data I found that the percentage annual average migration from large to small was 1.4 percent. It actually increased slightly to 1.6 percent in the more recent period beginning in June 2000—slightly more large companies were becoming small companies than was historically the case. In terms of the percentage of small companies migrating into large companies, the full period percentage was 9.1 percent. Over the more recent period beginning in June 2000, the percentage did decrease, though only slightly to 8.9 percent.
Overall, there doesn’t seem to be any significant change in migration patterns. The conclusion you should draw is that the proportion of stocks that migrate varies over time and is not predictable from one period to the next.
Next, we turn to the question of profitability.
As the authors of the HBR study noted, the profitability gap between large and small companies in the U.S. has widened dramatically over the past 25 years. Before we dig deeper, note that this is mainly attributable to recent growth in profitability for U.S. large caps. As my co-author, Andrew Berkin and I note in “Your Complete Guide to Factor-Based Investing”, before drawing any conclusions from data you want to make sure that the findings are not only persistent but pervasive around the globe. Otherwise, the result might be a purely random outcome or the result of a data-mining exercise. Data from Dimensional shows that the weighted average profitability of large companies in the developed countries ex-U.S. was virtually unchanged over the period from June 1990 through June 2019, and it had slightly declined for large companies in the emerging markets. Thus, we can conclude that there is no global pattern of increasing large company profitability.
We turn now to the issue of R&D spending.
Research and Development Spending
A third claim of the paper is that large companies are increasingly likely to maintain their dominant positions over small companies. The authors conclude that the primary reason for this is the widening gap in R&D expenses between large and small companies. For example, the authors state that the average large company spent $330 million on R&D in 2017, while the average small company spent only $6 million. It’s not surprising to observe large companies spending more on R&D in absolute dollar terms than small companies. A more meaningful assessment is to examine historical R&D expenses relative to operating expenses 1. Dimensional has data going back to July 1974. Examining the data, they found that the R&D-to-operating expense ratio indicates that, in aggregate, large and small caps have spent a similar fraction of their total operating expenses on R&D.
We can also look at the global data on the investment performance of small and large caps.
The data below looks at the annualized returns over the 20-year period ending September 2019.
- U.S. Large (CRSP 1-5) 6.6 percent versus U.S. Small (CRSP 6-10) 9.2 percent.
- MSCI EAFE Index 4.2 percent versus MSCI EAFE Small Cap Index 7.4 percent.
- MSCI Emerging Markets Index 7.6 percent versus MSCI Emerging Markets Small Index 7.4 percent.
As you can see, while small emerging market stocks slightly underperformed, there has actually been a large size premium in the U.S. and in the non-U.S. developed world.
Before concluding, there’s one other important point to consider. The increasing profitability and market concentration in the hands of a small number of very large companies brings its own risks in the form of regulatory scrutiny and the threat of anti-trust regulations.
The bottom line is that there doesn’t seem to be sufficient evidence for investors to consider abandoning the hypothesis that small companies should outperform over the long term as the evidence of a size premium is persistent, pervasive, and intuitive. (see here for a piece by Wes that covers the debate). And with the dramatic decline in trading costs, it’s also an implementable strategy, especially for those that engage in patient trading, providing, instead of demanding, liquidity. In addition, the correlation of the size premium to the market beta premium has historically been relatively low at about 0.2. Thus, adding exposure to the size factor not only provides exposure to an expected premium, but it also provides diversification benefits.
- Operating Expenses are defined as cost of goods sold plus selling, general, and administrative expenses plus interest expense ↩