The 2-Minute Thought: How Big Can a Company Get?

A recent column in The Economist suggested that Apple is testing the natural limits of company size.   It’s not a new idea. It seems natural to expect that something would happen eventually after a company gets so big and dominant – something like market saturation, competition, backlash, missteps, or product obsolescence. 

Every age has had its mega-companies.  There was the age of General Electric, the age of IBM, etc.  But how big can a company get before it stops growing and starts shrinking? 

It’s a question in play not just for Apple, but also the likes of Alibaba and Amazon.  In the words of The Economist, “There are no iron laws, but common sense suggests that there are limits.  Vast profits might reflect products that cannot possibly become any more popular, or a concentration of power that invites a competitive or political backlash.” 

The Economist looks at six giants from the past to put Apple’s size in historical context.  One is the East India Company, which started in 1600 and was formally dissolved in 1874.  The others are Standard Oil and U.S. Steel in the beginning of the 20th century, AT&T and IBM in the late 1970s and early 1980s, and Microsoft in the late 1990s.

At their peaks, each of the six companies had profits between 0.08% and 0.54% of GDP.  At the top is the East India Company, and near the bottom are Microsoft and IBM.  Today, Apple’s profits are at 0.28% of GDP, which puts the company well into the danger zone.  If history has a say, Apple won’t go on like this too much longer.

Perhaps more surprising is that Apple’s return on equity (ROE), according to Bloomberg, is now 41%.  That is absurdly high.  The average ROE for the S&P 500 today is 14%, and it’s been 12 - 14% the last five years.  Keep in mind, though, that we are in a time of high profitability, and that ROE for big corporates is expected to grow in the near future.

But that brings up another worry.  Bloomberg’s forecast for the S&P 500’s ROE is 19.8% in 2019.  That’s a level never seen the last two decades.  For purposes of comparison, average ROE for the S&P 500 was 18.6% in 1999, at the height of the internet boom.  It was 2.9% in 2002, 17.7% in 2006, and 4.3% in 2008.  Just how is it that the big companies in the S&P 500 can be so profitable relative to the past? 

The suspicion is that profitability has increased because there are fewer companies, and they’re larger.  The big have been crowding out the small, and there are real concerns about growing industry concentration and monopoly power – though there is some disagreement about this.

The Economist suggests there could be legitimate reasons for not worrying about Apple’s big share of GDP.   One is that today’s giants are more global than ever, so perhaps comparing corporate profits to the GDP of a single country doesn’t make sense.  But then again, the magazine also notes that Amazon’s profits as a share of world GDP in 2027 are expected to be twice as big as the East India Company’s at its peak in the early 1800s.  That’s domination. 

The 2-Minute Thought: Mid-Year Market Review

The pink chart below from last Friday’s Financial Times tells us a lot about where we are in markets now:

 Source:  Financial Times

Source: Financial Times

The indomitable FANG or FAANG stocks remain indomitable (that’s Facebook, Apple, Netflix, Google – plus Amazon if you do the double A).  Though there was a brief moment of doubt earlier in the year, it passed in a twinkle, and since then, the tech mega-platforms have left the S&P 500’s total return of 2.7% in the dust.  Amazon is up 45% year to date.  Netflix has nearly doubled. 

Next has been oil’s resurgence.  While few talked about oil at the beginning of the year, now everyone does.  In the second quarter, the S&P 500 energy sector topped info tech and returned 12.7%, its biggest quarterly gain since 2011. 

Small caps are another notable winner -- presumably because the domestic focus of small companies means they’ll suffer less than large multinationals if a trade war breaks out. 

Meanwhile, on the negative side, the strong dollar has punished emerging markets.  Gold has failed to become a safe haven in spite of a perception of heightened risk.  The Shanghai market is curiously weak.  And wild Bitcoin?  It’s down nearly 60%.

While not much is clear now, one thing that is is that buying momentum stocks still is working.  Momentum investing – the practice of buying what is doing well and rising in price – is trouncing value investing – the practice of buying what is excessively cheap.  Momentum also is trouncing the overall market too -- thanks largely to those aforementioned FAANGs. 

Since the start of 2017, the S&P 500 Momentum Index has outperformed the broad index by 15%, a level of excess return not seen since early 2008.  That kind of extreme outperformance suggests that momentum investing’s time will soon be coming to an end.  After all, nothing can grow to the sky forever.  Or can it? 

We don’t think so.  But value investing’s time has been a long time coming for a long time now, and it still hasn’t come.  Momentum stocks, meanwhile, are up nearly 9% year-to-date. 

So value investing’s time is either coming in a big way, or it’s not.  Eventually, we’ll find out.  And when we do, we’ll know what turned out to be the biggest mistake for value investors this period.   

Will it be failing to understand that big technology platforms need to be valued differently than other companies?  To be fair, Apple and Google have been viewed as value stocks at different times over the last half decade, but is it possible that value investors failed to recognize there are different rules for understanding the businesses and financial statements and valuation ratios of the real high fliers like Amazon?  

Or will the big mistake turn out to be losing patience at precisely the wrong time?  After all, the patience of value investors is being seriously tested, and the temptation to give up on value and give in to FAANGs seems to grow every day.  What a shame it would be if it turns out that large numbers of investors do so at exactly the wrong time.