Don’t back the dinosaurs – why smaller stocks are better bets

Investors put most of their cash into the big lumbering beasts of the business ecosystem. But they're doomed to extinction, says Jonathan Compton.

About 65 million years ago, every creature with a body weight of more than 25kg was wiped out in a mass extinction. Palaeontologists will bicker forever about why it happened. The causes seemingly included meteors, volcanoes, climactic shifts, changes in food supply, and even evolutionary disadvantages arising from laying eggs.

All we know for sure is that after a period when the dominant species were gigantic, nature has never repeated the experiment. In short, the dinosaurs grew too large and could not adapt.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Why am I talking about dinosaurs in a financial magazine? Because despite this lesson about size mattering a great deal, dinosaur companies hopeless lumbering beasts have always been popular.

Every investor with a pension fund is sure to hold several of these monsters, believing them to be safe' long-term holdings. Yet many will struggle to survive in the long term. Most will gradually sink back into the primordial slime of microcap stocks.

Take J&P Coats (subsequently Coats Viyella). In 1900 it was one of the top ten listed companies in the world. Founded in 1802, it specialised in weaving and threads. Within 50 years, it began to dominate its sector.

As the preferred supplier of army uniforms for the British empire, the first half of the 20th century was the best of all possible times for the company.

For the second half, it struggled with new materials, competition and a changing industrial landscape. It was put to sleep via a takeover and delisting in 2003, at less than 1% of its real (ie, inflation-adjusted) value a century earlier.

Yet, for decades after its glory years and despite the writing on the wall, it was seen as a prudent choice for conservative investors with a long time horizon.

The hold that these dinosaur companies have on investors is quite incredible. No one is certain how many listed companies exist globally, but the best guess is about 50,000.

On 30 June this year, the top 100 companies had a market capitalisation of $17trn about a quarter of the total $67trn value of all listed companies. The top 500 companies weighed in at $33trn, nearly half the total.

The investment bottom line is simple: investors have 50% of their money in 1% of the world's listed stocks. This represents concentration risk on a heroic scale. Particularly as I'd say that a good third of these companies are thrashing around like large sharks in a small, foodless tank: their demise is inevitable.

Stash of the Titans

Mega-cap stocks are often defined as those with a market cap of more than $100bn, while large caps have market caps more in the range of $10bn$20bn. These definitions have risen in size over time as the asset-management industry has grown and continues to pump its clients' money into large, decaying stocks.

There is a wide range of large-cap indices such as the Dow Jones Global Titans 50 and large-cap funds. Investment banks, fund managers and investors seemingly love these, despite a history of poor performance.

Why? There's an entrenched belief that big is safe, along with the comfort factor that comes with investing in familiar names. Liquidity is another attraction you can easily invest a billion dollars in a Titans index in a single day, and investors in large-cap funds feel comfortable that they can usually sell quickly too. Then there is the bunching' factor.

For all the alleged intensive analysis that goes into stock selection, and the individual flair which many managers claim to bring to portfolio construction, the majority are trend followers, who want to own the same stocks as their peer group.

After all, if a fund manager dares to invest in what he really believes are the best companies irrespective of size, country or sector weightings, and performs well, his fund will be deemed volatile', thus high risk. This in turn will affect his fund's (usually subjective) rating by agencies and consultants alike anathema to many of the largest investors.

So any manager who wants to raise new money is all-but coerced into index bunching around safe' mega-cap companies. Lastly, popular funds attract large inflows. Any good performance enjoyed when the fund is smaller becomes impossible to replicate, as size forces the manager to invest in these walking wounded companies.

Yet, despite this fondness fund managers have for them, many Titan and mega-cap stocks like the dinosaurs are simply too big to survive in the long run, even if their absolute size seemingly makes their demise impossible.

To put the scale of these stocks into perspective, if you take their market caps as being equivalent to the gross domestic product (GDP) of a country, then many would rank in the top quarter of the world's nations.

Tech giant Apple has a market cap of just under $500bn, making it the same size as Belgium, the world's 26th largest country. Six years ago, US bank Wells Fargo was teetering on the edge, but its market cap is about the same size as the GDP of Egypt and Finland.

Two of the Titans are pharmaceutical companies, Roche and Novartis. Combined they are about the same size as Norway (No. 23) and two-thirds the size of their home country Switzerland (No. 20). On an asset basis, these Titans are even more vast.

JP Morgan Chase has total assets of $2.4trn. On a GDP basis, this makes it the seventh-largest country in the world, just ahead of Brazil. HSBC's total assets of $2.7trn are larger than the UK's GDP.

Feeding the beast

Why is size a problem? Because for behemoths like this, it takes huge effort merely to maintain sales and profits, let alone improve them.

I met a retired director of GlaxoSmithKline last year, who bemoaned the fact that every hour he had to sell hundreds of thousands of pills, merely to feed the beast' of earnings, and every year was expected to sell hundreds of thousands more, despite rampant competition and pricing pressures from government buyers.

As if this were not enough, large drug companies have been spectacularly poor at creating, then selling, new blockbuster drugs, which they must do to survive.

One problem as anyone who has worked for a giant corporation will know is that companies this size are deeply dysfunctional. Baronies and fiefdoms abound.

International companies suffer ongoing national turf wars as different divisions compete to take over the responsibilities of their offshore counterparts. This may explain why, at a certain size, companies seem to be rendered incapable of innovation.

For example, in the 1980s, Nintendo's pioneering handheld games were ubiquitous, as was the Sony Walkman. Both companies were Titans, but have struggled to make any profit at all for the last 20 years.

Microsoft's main business of selling Windows operating software is, like J&P Coats, becoming redundant as technology moves on. Walmart remains the world's largest retailer, but has suffered falling profits for seven quarters in a row.

McDonald's has woefully underperformed rising markets in the last two years there is a finite number of burgers that even an ever-fatter world population can consume.

HSBC's share price is lower now than at the start of 2000. Vodafone, meanwhile, is held by over 95% of all UK-listed funds and private clients investing domestically yet it is well below the £4.12 high set in 2000 (although it has paid significant dividends).

The company is symptomatic of a telecoms industry which has been a slow adapter to the technological changes it created. Most are in a genteel decline in terms of profitability.

And any new investor in Apple requires almost religious fervour on several counts. It requires belief the company won't blow up, as every other business which has become large enough to join' the G20 group of the world's leading economies has done; belief that after three hugely innovative products over three decades, the trick can be repeated (which no high-tech company has yet achieved); and belief that Apple can stay ahead of the competition in technology, design, costs and marketing.

The Titans and dinosaurs will mostly be around in ten years' time, but it is inconceivable and mathematically impossible that more than a few can either beat the index or grow their profits much faster than the rate of global GDP growth (and don't hold your breath for excitement there).

Poor returns

Titan companies have admittedly had a good run in the last 12 months, due to a mixture of cheap borrowing (often used to buy back their own shares) and the easy-money-fuelled mild economic recovery. Even so, they have been beaten by the rest of the market.

Over the last five years, the FTSE Global Large Cap index has underperformed the Small and Mid-Cap, the Global All Cap and Global World indices. This is not unusual. Longer-term returns show a similar pattern.

Excluding dividends, the Dow Jones Global Titan 50 index has an impressively awful 15-year return of minus 9.6%, versus a small positive for other world indices. Funds investing in mega-caps, and over-large funds, show a similar pattern of underperformance.

Dinosaur companies take years to die because their huge balance sheets take a long time to decay. During this process, most try periods of reinvention by selling off less profitable areas or closing non-core' divisions one rare success has been IBM since the mid-1990s.

Often, in a futile attempt to regain their mojo, there is a burst of frenetic takeover activity of their smaller, more innovative rivals. Vodafone has thrown around takeover money like confetti for years, but has had to write off billions of pounds through overpaying.

Like the pike, a rare survivor from the age of the dinosaurs, these companies will devour everything in their pond and thus end by killing themselves.

The problems suffered by giant companies do not mean that small or micro-cap stocks are particularly worthy. There are thousands of stinking fish in the bottom of the hold (and too many cases where stock exchanges should not have allowed them to list).

Yet there are also several thousand companies with a market cap of between £1bn and £10bn, which still have room to grow, but are also small and flexible enough to adapt to changing conditions.

Some will be taken out by their struggling giant competitors, while over the very long term, some will become dinosaurs and Titans and their own extinction will commence but either way, great returns are available between now and then. I look at four promising options below.

The four stocks to buy now

In their death throes, dinosaur companies will eat anything insight in the hope that acquisition is the solution to their sizeproblem.

So, I've looked to find the sorts of reasonable-sizedUK companies with strong cash flow that investment bankerswill offer to these troubled giants or that could become giantsthemselves. (I have a small interest in all except Morrisons.)

William Morrison (LSE: MRW) has been a horror story sinceits hubristic takeover of Safeway and subsequent failure toimprove distribution or move into internet sales. Worse, itplans to maintain its dividend, a decision which has rightlybeen described in the business press as bonkers'.

The share priceaction over the last five years has been horrible, withthe market cap shrinking to £4bn. Revenue per employee andreturn on assets have been falling, and management is weak.

Yet the companystill has sales ofover £17bn, and 450stores. In retailing,consolidation is

seen as the routeto growth, so it isnot hard to imaginea local or foreignretailer moving in.

Similarly, Ladbrokes (LSE: LAD) has been a white-knuckleride, falling from £2.50 in early 2013, to around £1.30 now.Unlike rivals Paddy Power or William Hill, it has been slow toadapt to the rapid changes in the industry (internet and mobiledevices) or in broadening its gambling opportunities.

LikeMorrisons, returns have been rotten versus its peer group, withan unappealing five-year growth rate in earnings per share of-25%. Yet it offers a chunky 6% yield which is just covered byearnings.

The market cap of £1.3bn would be a low price to payfor any group wanting to be in the ever-popular leisure industry,whilst there are also unlikely to be competition issues.

Twoother bonuses are that most analysts don't like it and there is nodominant shareholder.

More positively, Smith & Nephew (LSE: SN) has been a steadyif dull performer over the last five years, increasing from £5.54per share with a steadily rising dividend. It operates in threeglobal segments: orthopaedics (knee and hip replacements),endoscopy and wound management.

There are other globalplayers, all US-based, such as the giant Medtronic (market cap$62bn), Stryker ($31bn) and the better-known Zimmer ($17bn),which is slightly smaller than Smith & Nephew at £9.5bn.

Ona price/earnings (p/e) ratio of 26, Smith & Nephew is hardlycheap but profits should rise steadily and its businesses areall in growth areas. A perennial takeover target, whilst makingsmall acquisitions itself, it is either a possible take-out target fora dinosaur, or a company that should steadily grow into Titanstatus itself.

The last company is relatively small, at £540m. Spirit PubCompany (LSE: SPRT) was listed as a spin-out from overindebtedPunch Taverns in 2011 and has nearly doubled its shareprice since then, to around 81p now. Its estate now consists of750 managed and 450 leased pubs, with plans to add 400 more.

Annual results in August beat expectations and the guidanceeven more so. Like S&N, the attraction here is that we either seeongoing steady growth, or a takeover by a dinosaur company inthe same sector.

Jonathan Compton spent 30 years in senior positions in fund management and stockbroking.