Large Cap Vs Small Cap : A Bridge Too Far
The gap between large-cap companies and small-cap companies is growing. Is there a tangible reason for this difference? Dalal Street Investment Journal investigates.
Research and news headlines often point to the idea that traditional large-cap companies cannot innovate and small-cap companies will render many large-caps extinct. Owing to the digital revolution, there have been numerous start-ups over the years that upon entering the market have not only caused disruption but become megacorporations of today. Are traditional large-cap companies of today at risk of becoming increasingly displaced by newer technologies? Or are these heavyweights more than capable of standing their ground? Before taking a call on this, it is important to consider how these companies have performed in the recent past.
We find that over the last two years, all three, namely, the small-caps, mid-caps and large-caps, have shown typical traits that embody them. As the country’s economic growth slowed, the BSE small-cap and mid-cap indices lost 24.69 per cent and 18.53 per cent respectively, while the BSE large-cap recorded a relatively modest decline of 8.48 per cent. We can see that while the overall economy passed through a slowdown, it was the small-cap and mid-cap indices that took the biggest hits.
Even if we consider 2019 specifically, before the outbreak of the coronavirus, the BSE Mid-Cap index had slipped by 3.05 per cent and the BSE Small-Cap by 6.85 per cent, even as the bellwether S & P BSE Sensex gained 14.38 per cent. Consequently, the price-ratio (or the ratio of respective indices) between the mid-caps and the Sensex had dropped to 0.069, the lowest in a decade as compared with the 10-year average of 0.086, according to Bloomberg data. The market-cap proportion of ‘A’ group shares on the exchange had surged to 94 per cent, the highest since 2000, as against the long-term average of around 84 per cent Investor preference for large-cap stocks over the years has caused a chasm between the market capitalisations of these scrips. In fact, the market-cap between the large-caps and small-caps is at a two-decade high. From the mid- 1990s, the size difference between the large and small increased continuously and rapidly, except for during the recession years of 2008-2009. So contrary to the popular notion, it is found that large-cap companies are more likely to maintain their dominant position while small corporations often tend to stagnate or even wither away.
Impact of Covid-19 Crisis on the Private Banking Industry
The notion is even apparent during the large correction we are currently seeing due to the coronavirus outbreak. There has been a large valuation gap that has opened up between top tier private sector banks and their smaller peers. While private sector banks have seen a 23.33 per cent decline in market capitalisation on an average since February 20, 2020, when the markets began to correct, many smaller banks lost nearly half of their market-cap. These include names such as IDFC First Bank, Federal Bank and RBL Bank, whose market capitalisation is down from Rs.17,445 crore in February 2020 to around Rs.6,681 crore at the close of trading on April 1, 2020. On the other hand, heavyweights such as HDFC Bank and Kotak Mahindra have lost around 30 per cent of their market capitalisation.
Many in the industry believe that this will polarise the industry between the top tier banks and the others as the decline of the share price is likely to make it harder for many of these smaller banks to raise fresh capital, thus forcing them to concede market-share to their larger peers.
Reasons for the Widening Gap between Small-Cap and Large-Cap Companies
According to a study by Harvard Business Review (HBR), there has been a significant change in the performance between the large-caps and small-caps which can be seen in median return on operating assets. This difference between the two was 15 per cent in the 1990s but has since doubled to 30 to 35 per cent. Large companies are getting more profitable, whereas smaller ones are suffering from persistent unprofitability. The gap in the fraction of companies reporting annual losses has widened too. Around 10-15 per cent of large-cap companies reported annual losses in recent years but that number is as high as 60-65 per cent for the small companies.
The main driver which has caused this gap between the small-cap and large-cap industries also happens to be a key factor of enterprise performance and growth – the rate of investment in tangible and intangible assets. This can be investments into research and development, brands, technology or human resources. There has been a dramatic increase in the gap between how much large-caps and small-caps invest in these intangibles.
The chart below shows that the difference between the mean annual research and development spending of large and small companies grew from less than USD 20 million in the 1980s to almost USD 120 million in 2017. The study found that on an average, a large company spent around USD 330 million on research and development in 2017 while the average small company spent a mere USD 6 million – clearly insufficient to keep pace with a large competitor.
Similarly, a growing divide can be seen in terms of expenditure on selling, general and administration expenses too, which often include intangible spending that directly relates to IT, brands and human resources. Large-cap companies are not resting on their laurels but have instead increased their investments in innovation and intangible expenditures. For example, large retail firms and banks are capitalising on advancements in artificial intelligence to aid their legacy operations. One might argue that this is normal. After all, companies like Amazon, Netflix and Mircosoft were, once upon a time, small-cap companies too. So the small-cap companies of today will fare similarly if not better.
However, it is found that small-cap companies of today are stuck in a ‘small size trap’ of sorts. In other words, it has become harder for small-cap companies to escape their group and transition into large-cap companies. In 2000, the percentage of small companies that became medium or even large companies was 15-20 per cent; this number was reduced to half in 2017. Similarly, 75-80 per cent of large-cap companies remained large companies the following year, but that percentage has increased to 89 per cent recently. So, the once familiar process of small companies growing organically to capture dominant positions – a typical scenario in the 1980s and 1990s – seems not so familiar in today’s world.
Small-cap companies of today are stuck in a ‘small size trap’ of sorts. In other words, it has become harder for them to escape their group and transition into large-cap companies.
Conclusion
Contrary to popular belief, there is waning evidence for the idea that large companies do not innovate or that their businesses are at risk of being disrupted by the smaller companies. The investment and growth opportunity set of small companies has been shrinking for a while, and their nimbleness and grit are increasingly under pressure. In contrast, the large companies are leading the way in terms of investing in innovation and intangible assets at an increasing pace, and seem better prepared to weather challenges from small companies than portrayed in literature.
On the one hand, this is good news: large companies are not basking in their glory but instead are innovating and maintaining their dominant positions through innovation and first-mover advantage. On the other hand, the fact that smaller companies are falling behind does not bode well for the economy, which, over the past century has been driven by the creation of global corporations based on new ideas and pursuits.