Mega-cap companies need special traits to become charging elephants
Mega-cap companies are generally thought of as those whose total value of all shares in issue is above $100bn. For context, that is more than four times the size by market capitalisation of Africa’s biggest bank, FirstRand.
To become gigantic, companies generally need to have had something special. Whether this something special will continue is key to determining which mega-cap firms may make good long-term investments. So what are the shared desirable characteristics?
- Diversification. Gigantic companies are generally much more diversified than smaller companies. Their businesses typically span geographic regions and have multiple products. At some stage all businesses experience some disruption. Being well diversified means difficulties in any particular region, or with particular products, do not cause critical damage to an organisation. For instance, British-Dutch consumer goods company Unilever is diversified by geography, operating in 190 countries, and operationally, with 13 core business sectors, the most exciting being ice-cream, tea, culinary products, hair care, skin care and deodorants.
- Predictability. This diversification helps to make the profits from mega-cap companies more predictable. Much modern finance theory encourages big institutional investors to value such certainty more highly.
- Economies of scale. Mega-cap companies typically have substantial economies of scale. From a financing perspective, ratings agencies typically provide higher ratings for mega-cap companies, enabling them to borrow for less. Size also confers operational advantages. US payment network operator Visa, for instance, is double the size of the closest competitor. This enables some mega-cap companies to be able to provide lower cost solutions than others.
- People. Mega-cap companies have the ability to attract and retain talent from smaller organisations, or simply to acquire them along with their market positions and technologies. US company Alphabet, parent company of Google and others, for example is expected to complete the acquisition of Fitbit by the end of 2019. In a stroke, the company not only adds 28-million active users and over 5% of the global smartwatch market, but also a successful team.
- Liquidity. Shares in mega cap are typically highly liquid. People and institutions regularly trade in these stocks. This results in lower transaction costs as the spread between bid and ask price is low, and enables positions to be bought or sold more easily than smaller companies. In “risk-off” environments, the relatively lower liquidity in smaller capitalisation stocks can mean share prices fall more dramatically than they do for larger companies when there are more natural buyers of shares.
Not all mega-cap companies will make good long-term investments. A useful, though perhaps slightly crude, analysis is to separate them into charging elephants and sluggish dinosaurs. Charging elephants tend to have found business niches that have facilitated growth. Typically these firms have either generated some form of intellectual property, a product or technology, or have a brand synonymous with quality. The research & development and marketing budgets of the charging elephants makes competing with them a substantial challenge.
For example, bringing a new single pharmaceutical product through all three phases of clinical trials typically costs upwards of $1bn, with considerable risk of failure along the way. UK-Swedish pharmaceutical company AstraZeneca has nine such new products in their late-stage pipeline. Most exciting for AstraZeneca investors, however, is the huge number of pipeline projects using medicines already approved for different indications and in different combinations. These typically have higher clinical trial success rates than new pharmaceutical products.
Another charging elephant is US technology giant Microsoft. Over the past 12 months Microsoft spent almost $17bn (R252bn) on research & development. To put this into context, there are only slightly over 20 listed software firms in the world with enterprise values over this amount. Or put another way, this level of spending, with no takeover premium, is more than the value of over half of the world’s other listed software companies. Microsoft’s products are ubiquitous. Challenging the firm’s dominance in any of a number of fields would require deep pockets.
Sluggish dinosaurs includes those that began as state-backed entities, and those operating in industries facing major structural headwinds, perhaps due to environmental or other social factors. Culture is exceedingly important to how organisations run and can be challenging to change. State-backed entities are typically inefficient and not staffed by entrepreneurial management. This generally makes returns on capital low and growth, outside any potential government backed monopoly positions, unattractive.
Being big brings benefits, but bigger isn’t always better. Being focused on the characteristics of quality mega-caps should allow investors to sleep easily while the companies they own charge on.
• Dr Cooke and Davey are fund managers of the Ashburton Global Leaders Equity Fund, whose holdings include Unilever, Visa, AstraZeneca, Microsoft and Alphabet.