Large-Cap Stocks May Be More Attractive Than Small Caps

by: Strubel Investment Management

Summary

The market is becoming increasingly dominated by larger companies.

The total number of publicly traded stocks has dropped by almost half.

The largest companies are growing faster then the economy as a whole.

In the investing world, both among market practitioners and academics, it's pretty much taken as gospel that investing in smaller underfollowed companies in out of the way places is one of the easiest ways to beat the market. While there is definitely truth to that notion, we don't think it is the only way to have success when it comes to investing. Indeed, we mostly invest in large and mid cap companies in the two stock portfolios we manage. We think there are two very good reasons that investors can be successful by focusing on larger companies. Over the last several decades there have been two powerful long term trends that favor investors in large cap companies and the large cap companies themselves. Those trends also look to continue for the foreseeable future.

The Pool of Companies is Shrinking

A large pool of under followed companies is one of the biggest advantages touted when it comes to investing in small companies. The thinking is it's easier to stumble upon an under followed and undervalued company that few other investors know about when the universe of potential investments is so large. However, the pool of small companies has been steadily shrinking from its high of over 8000 in 1996. Indeed, as of last year the number of public companies has fallen to 4,333.

(Graphic via Yahoo)

This is below the number of public companies that were trading back in 1977. Despite an economy and a population that has grown tremendously since 1977 we actually have less companies to invest in now!

Investing in small companies also might give an investor the opportunity to buy into a great business "on the ground floor". We all know what a dollar invested in Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN) or Google (NASDAQ:GOOGL) at their IPO would be worth now. Lately though it seems this opportunity is becoming increasingly rare. It's becoming more common for fast growing tech companies to remain private even as they grow into valuations that would place them in the large cap stock arena. Companies like AirBnb with a $31B valuation, Palantir with a $20B valuation, and Uber with a $28B to $70B valuation are all private and don't seem likely to go public soon. Companies are going public at much later stages in their life and this limits the amount of high growth companies available to investors.

The Economy is Becoming Increasingly Concentrated

The second and probably biggest trend that favors large cap investing is that the economy is becoming increasingly concentrated. Companies are becoming increasing larger and gobbling up their competitors and forcing smaller companies out of the market.

The retail sector probably offers the best, easiest to see, first hand evidence of this trend. Retail used to be dominated by locally owned "mom and pop" shops. Around the 1900s large chain stores began to form and spread across the country. General merchandise and groceries for example were now carried by regional and national stores (Sears, Piggly Wiggly, etc). Mom and pop shops still had a role in specialty retail and the chains didn't quite have enough market power to squeeze out the competition. Wal-Mart and the rise of the big box stores with substantial economies of scale and market power put most remaining small and regional retailers out of business. Finally, as retail sales moved online only one company, Amazon, dominates. This concentration in corporate power isn't just happening in the retail sector, it's happening all across the economy.

Look at the charts below from the Bureau of Labor Statistics. The first one shows the percent of employees employed at small businesses versus large businesses.

The second chart shows the number of jobs created by new small businesses.

Small businesses are where the next public small cap companies come from. As the number and size of small businesses declines so too does the number of future small cap stocks.

What you have is an economy where most of the growth is going to relatively few large firms. The following graphs from FiveThirtyEight shows the revenue the Fortune 100 and Fortune 500 earn as a percent of GDP.

You can see that large companies have been growing at a rate faster than the overall economy. It also shows that the bigger a company is the faster it grows in size. The graph below shows the Fortune 100 compared to the Fortune 500.

So not only are large companies taking market share away from small companies the largest companies are even taking share from other large companies! Large companies are growing larger and the largest companies are becoming market-dominating mammoths.

Investment Implications

What this data means to us is that it looks like it is becoming increasingly hard to identify promising smaller companies that an investor can own for the long term. Not only is the pool of potential investments shrinking but the economics of being a small company are deteriorating. As larger firms gain more dominance in the marketplace, it becomes harder for small firms to compete.

Please don't take this the wrong way. It doesn't mean that there are no good small cap investments and every large cap company is a great buy. What it means is that, statistically speaking you are now much more likely than in the past to find a company with attractive market dynamics in the large cap space than in the small cap space. If you think of picking stocks as fishing, you want to fish in the lake with all the fish and right now large cap companies are the lake with all the fish.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.