April 12, 2008

Large Cap and Value Investing

GE announced their earnings on Friday and was the catalyst for a large sell off in North American markets. That got me thinking about the merits of investing in a company like GE and theorized that large cap companies are not a good investment for long term horizons. Do not get me wrong GE is a great company and their management is second to none but at that size most likely it would never offer an above average return.

Lets take the example of GE over the last 10 years; GE's returns were meager compared to the index. GE appreciated a cumulative 11% compared to the Dow Jones 37%. If you factor in the dividends, GE's cumulative total return is 37.74 % compared to the Dow Jones 44.34%.

To invest in large companies like GE, CISCO or Exxon you have to remember three things:

  1. Over the long term, you are not likely to yield any above average returns compared to the whole market. The earnings growth of companies like these will never exceed the nominal growth in economic GDP.

  2. You have no information advantage. Large companies are analysed to death by hoards of analysts and investment professionals and believe me they do far better job than you and I when it comes to investing institutional funds in a company like GE, so it is fair to say that large cap companies are rarely under valued.

  3. Large cap companies are complex to understand. I try to stay away from analysing them as they overwhelm me with the all their moving parts. A true picture of economic drivers is not easy to understand. Moreover, to arrive at an intelligent risk assessment of these companies is extremely difficult. Looking at historical earnings and dividend growth records or ratio analysis of various financial statement metrics is not suffice to understand and arrive to a company intrinsic value. This framework is akin to driving by always looking in the rear view mirror; an extremely dangerous endeavour.

Large cap companies can offer good returns, however those occasions are very rare. For example, Altria came under huge distress with all the the tobacco litigation in the 1990s and was sold off due to the uncertainty surrounded the litigation. Investing in Altria then was a good move. Another example is Merck with its Vioxx suit. Smart investors analysed the situation and deemed that this uncertainty does not impact the underlying value of the franchise and in that instance large cap companies offered exceptional returns.

The conclusion here is a buy and hold strategy of large cap companies will achieve average or sub optimal returns compared to the market index, however investors will bear higher risk due to the specific operations of the company. You can only get good returns from these large cap when they are engulfed in uncertainty about their prospects, while the competitive advantage or the franchise value remains intact.


MG said...

I disagree with your assesement here. Large cap companies offer lower risk and dividend growth that trumps smaller caps in many ways. Just because GE has underperformed the Dow index over the past few years means nothing. The size of a company does not impair it's ability to grow in any way.

Sami said...

Like I said Those behemoths are hard to understand, at least for me, moreover I do believe that there is a constraint on growth once you reach a certain size. Beuacracy sets in and decisions are not as easy to make, excecute or monitor.

Having said that, I said there are times when it makes sense in investing in those, but you have to pick your spots.