Little Safety in Big Caps

July 2008 Dr. Hans Black

Many market participants have been involved in an active debate for most of this decade on whether or not to emphasize large cap securities or their better performing small and mid cap cousins. This has been a debate that has generated a lot of passion, as we can attest to in the numerous conversations we have had with our clients and friends. The rallying cry of the large cap investors has essentially been that their large size represents safety and that with that size, their ability to raise capital is usually unquestioned. The small and mid cap argument, which to a certain degree we have championed, revolves around the idea that the sector offers a larger diversity of choice, greater innovation and flexibility, and the opportunity to invest on the cutting edge of terrific new ideas and concepts forwarded by many extremely talented and highly motivated managers/owners.

In recent months, the large cap advocates have been forced to amend their argument somewhat, stating that perhaps very large cap companies are not desirable, but most large cap companies still are. This revision has been somewhat forced upon the debate due to the extremely poor performance of some of the major large cap companies globally, GE, Pfizer and BP being prominent examples. It should be noted that the recent collapse in the value of many large cap financial companies, notably in the banking sector, is not at the core of this debate, but rather perhaps that underlying conditions in the credit markets have exposed weaknesses that have accentuated certain levels of underperformance.

Few can deny that we have been living through a period of extraordinary change in capital markets. Over the past ten years, markets have indeed become much more global and the presence of multiple financial hubs - not just London and New York – has caused widespread and profound changes. The impact of sovereign wealth funds, the degree to which debt securitization has become increasingly complex and opaque, and the connectivity between developed and developing markets are only three examples. When an investment banker in London decides to promote a new product which perhaps has at its core G7 consumer loans, the risk is rapidly passed on to portfolios all over the world. It is not at all unlikely, for example, that a large sovereign wealth fund in Norway could unknowingly have a very meaningful exposure to the fortunes of the consumer in Nevada. Policy makers and central bankers have been caught off guard in the past year as the complexity of these inter-relationships has caught many wrong-footed, if not wrong-headed. The very real fear that large global players could actually default has led to heightened appreciation of counterparty risks, which have not always been predictable and have never been transparent. It is interesting to note, when reading through the as yet developing history of the Bear Stearns collapse, how quickly these events overwhelmed a large investment bank. In reading the now recently published Federal Reserve Board minutes, it has become clear that at the end federal regulators felt they had only a matter of hours in which to act in order to assure a smooth functioning market.

In an environment of such rapid change, the challenge of running large global companies has become increasingly difficult. Economic presumptions made in past years can quickly be called into question, and the ability to redirect an organization that is managing a revenue base of $50 billion or more is quite difficult. In addition to that, senior managers are constantly being challenged by the investment community to produce ever better results, forcing reliance, perhaps too often, on very short term thinking. The environment that began with problems in subprime and has now spread to real estate in much of the G7 and, by extension, to most credit markets, has proven to be very difficult for quite a number of organizations. It should be emphasized that we are not talking here exclusively about UBS AG or Citigroup, but we are also focusing on other leading companies that have stumbled in recent years by not being able to meet growth expectations or, more importantly, adapt yesterday’s business model in order to ensure continued prosperity in today’s environment.

Pfizer is an interesting example of a dominant company which lost its way, as they decided many years ago to grow through acquisition; and thus ignoring the growing problems within their own research and development pipeline. As a result, it is now actively seeking strategic partnerships or outright acquisitions of smaller, more nimble, players in the pharmaceutical field. The pharma and biotech sectors contain many wonderful examples of how large cap companies have continued to buy mid and small cap enterprises with a combination of ingenious products and motivated owners/research staff, and in our view, this is a trend which still has a long way to run. The price Takeda Pharma paid earlier this year for Millennium, over 75x trailing earnings and over a 50% multiple to where the stock was trading, is an example of paying up to ensure that the pipeline is filled.

Many larger cap companies are also faced with problems related to legacy issues. More often than not, new CEO’s find it difficult to redirect an organization where both the board and previous senior management have bought onto a particular strategy. In a recent interview given by Steve Ballmer, CEO of Microsoft, he made some uncomfortable comparisons with a number of other large cap companies that have really not made any money for investors for quite a number of years. I would hasten to add that Microsoft is in an infinitely better position to grow moving forward than many of its more dated blue chip brethren. While it should be noted that Mr. Ballmer’s comments were perhaps more directed at the lack of performance and difficulties seen by companies such as General Electric and Hewlet Packard, it is also worth noting that the price of Microsoft today is trading virtually identical to levels seen exactly ten years ago, while General Motors is at levels last seen in the early 1960’s.

Many of the biggest successes in the stock market over the past ten years started as relatively obscure or even unknown small cap entities. Google, of course, is a great example, but other companies such as Apple, who pioneered new products into a very successful dominant position, are also worth noting. Newer technologies, whether they be related to power storage companies or technology companies, software or communication and, of course, healthcare companies in the biotech sector, are being developed by young, well-managed companies that are exploiting excellent new avenues of intellectual property. Looking forward, we see an investment landscape ripe with opportunities as the paradigm continues to shift toward the quick and the bold. We believe the dramatic change in energy pricing in recent years will lead to an overall series of success stories for those enterprises that will be able to make transportation more efficient or enable us to store and move energy more cheaply than we can now. The growth of the solar and wind power industries is just another example of how at times smaller enterprises can flourish by developing really good ideas.

The changing preferences of baby boomers in general, as they shift their focus from consumption to enjoying their golden years, is going to dramatically alter their spending patterns. Today’s boomers generally want to stay healthy and enjoy life irrespective of how much that will cost their insurance companies or the government. They are generally willing to do with less, for example trading down to smaller homes, so that they can continue to travel and do things. Health care spending in the G10 should continue to grow as a result and the emphasis will be on quality of life. Their desire to travel and experience things, whether through travel or high-definition flat screen televisions, is going to create new needs for companies to fulfill in a more value-added and efficient way than in the past. Consumers will emphasize better nutrition, as there seems to be a global push toward healthier eating and healthier products. The marketplace is changing so quickly and larger companies are finding it increasingly difficult to anticipate and refocus their efforts and, in the process, are starting to see the comfortable niches of the past erode. Do the great consumer companies of today really deliver what consumers want? The underlying fundamentals are improving on a global basis but increasingly, we sense that consumers will seek out niche products be they for health, food, entertainment or learning. In the food industry, for example, there are sectors that are growing tremendously, such as healthy products, soy, etc., while basic staple products show very difficult growth patterns and exceedingly challenging markets. Perhaps the environment of tomorrow is that we will see large retailing organizations such as Wal-Mart and Costco dominate basic products while a whole host of specialized companies come up with products much more tailor-made to the individual or to the individual in a particular region.

It is perhaps all about the increasing power of the individual to demand products customized for himself. The question then becomes, "can" larger enterprises successfully fill that need? We are increasingly convinced that the successful companies of tomorrow will need to deal with consumers as individuals and cater to their needs, as diverse as they may be. Walking through a shopping mall in Abu Dhabi recently, one cannot help but be shocked to find so many of the same brand names – Sak’s Fifth Avenue is there – indeed major luxury labels are all present, and all competing with the same products, while individuality is most often expressed in smaller stores dealing with specific local needs.

This point of individuation is perhaps best illustrated in the area of biotechnology. It is worth noting that one of our more promising sectors in oncology right now is the trend to develop treatments in cancer specifically for the cell type affecting a patient. Companies that can design solutions for neoplasms based on specific cell type will be richly rewarded in our view. Before you think that this is a chapter out of "Star Trek", a recent conference for the biotechnology industry in San Diego featured exactly these themes, namely the production of health solutions specifically designed for the individual or small groups of individuals who have similar needs.

Can larger organizations compete in such a complex and rapidly changing environment? Here we believe lies the eventual answer to stock performance in large cap versus small or middle cap companies. Large cap companies, in our opinion, will increasingly look to leverage their financial resources and marketing economies by partnering with more innovative and flexible small and mid cap size companies. While these new relationships will accrue benefits to both the large and small companies, our view is that past the current environment investors are likely to be more richly rewarded focusing their sights on the more nimble and adroit mid and small cap sectors.