Most large companies find it very difficult to grow consistently faster than the market in which they operate. There will be periods when they take market share from competitors but these are usually followed before too long by periods where their competitors take it back again.
As a result, their share prices will oscillate in the relatively short term, but over the years growth is likely to track the GDP growth of the major countries in which the group operates. That is why chief executives get so seduced by financial engineering ? be it shrinking the equity base and piling on debt or buying out competitors to provide scope for cost-cutting.
It creates the illusion of growth, and sometimes even delivers a period of outperformance that, if all goes according to plan, will last long enough to trigger the chief executive?s bonus. It is so much more exciting than slugging it out with competitors in a thousand local markets.
Small deals close to the acquiring company?s area of expertise are the most likely to deliver benefits but the bigger the deal, the more likely it is to fail to deliver long-term value. The early gains from the cost-cutting give way to the added costs that come with greater complexity and the loss of management talent, knowledge and focus as the different business sets of executives fight for supremacy and stitch each other up in a hundred different locations across the globe.
But boards clearly do not have enough excitement in their world because they keep doing deals despite the odds being stacked against them, and this year is no exception. Figures published yesterday by Towers Watson from research done by Cass Business School said there have been more billion-dollar deals this year than ever before.
The data show that so far this year worldwide there have been 11 mega-deals worth more than $10 billion (£6.36 billion), 165 deals worth over $1 billion and 844 deals worth more than $100 million ? all totals that are up quite a bit on last year.
An interesting aspect of this research is that it has been used in the past to support the claim that deals work, and there is a whiff of this in yesterday?s announcement. It emphasises how the acquiring companies have outperformed their respective markets in Asia and Europe over the last three years. However, it also acknowledges that in the US, where most of the deals are done, the trend has been the other way ? the acquirers have underperformed.
One might expect early outperformance, however, because it is in the early stages that the easy-to-reap benefits come through. The problems usually take a bit longer to surface ? except in those cases where the real but undisclosed reason for the deal in the first place was to hide some horrible problem inside the acquiring company.
This seems as good a time as any to mention ? indeed to recommend as a stocking-filler ? a new book called The Future is Small*, which is written by one of the City?s most respected fund managers, Gervais Williams.
In the foreword, entrepreneur Luke Johnson makes the point that if the next few years continue to be characterised by weak global growth, this hits big companies much more than small ones. The giants struggle to put on sales while small firms are usually much more nimble and adept at finding opportunities even in tough times.
Williams adds that big businesses tend to be bureaucratic, lack flexibility, find it hard to adapt to change or to innovate, and so begin over time to decay as they reach the end of their natural life cycle. He also cites some interesting research that seems to suggest the productivity of employees goes into decline when the payroll rises above 250. Altogether from an investment standpoint, small companies are a much better bet.
Williams is a small-company specialist, so he would say that anyway, but he produces some stunning statistics to back up his case. Long-term comparisons have to be treated with a degree of caution but nevertheless he shows how £1 invested in the stock market 50 years ago would have grown to £1070 if invested in the FTSE All Share Index but would have delivered £4,907 if invested in the Numis Smaller companies Index.
But if it had been put into the DMS Micro Cap Index ? of companies that are smaller still ? that £1 would today be worth £21,585. A similar analysis done for the US shows a single dollar growing to $3919 if invested in large caps, $29,400 if invested in small companies and $48,090 if invested in micro cap businesses. Well, you might ask if the advantages are so obvious why doesn?t everyone do it? There is no single answer. Part of the problem lies in the nature of modern fund management, where the funds are so large that they can?t all be invested in small firms. Part of it is time horizons and liquidity. It can be hard to sell a large slice of a small company in a hurry, while there is no trouble trading in and out of Tesco.
No one should buy small-company shares unless they are prepared to stick with the investment for a long time. It is about years, even decades, not months. Modern fund managers don?t want to wait that long. And, of course, it is difficult. Spotting the opportunities in small companies is a lot harder than trading in and out of the FTSE 250.
But having said that, the world is going Williams?s way. The Department of Business Innovation and Skills yesterday reported a huge upsurge in interest among young people in starting their own businesses. The whole thrust of the internet and modern technology favours the young, small and nimble. What we now need are more fund managers like Williams willing to do the hard work of identifying them.
*The Future is Small by Gervais Williams Published by Harriman House £16.99.
