The case for global mega cap investing

Mega cap companies are generally thought of as those whose total value of all shares in issue is above $100 billion. For context that is over four times the size by market capitalisation of Africa’s biggest bank, FirstRand. 

To become gigantic, companies generally need to have had something special. Whether or not this something special will continue is key to determining which mega cap firms may make good long term investments.

So, what are the shared desirable characteristics of mega cap stocks?

Diversified investments. Gigantic companies are generally much more diversified than smaller companies. Their businesses typically span geographic regions and have multiple products. At some stage all businesses experience some disruption. Being well diversified means that difficulties in any region, or with particular products, do not cause critical damage to an organisation. For instance, British-Dutch consumer goods company Unilever is diversified both by geography, operating in 190 countries, and operationally with thirteen core business sectors the most exciting being ice-cream, tea, culinary products, hair care, skin care and deodorants.

Predictability. This diversification helps to make the profits from mega cap companies more predictable. Much modern finance theory encourages big institutional investors to value such certainty more highly. 

Economies of scale. Mega cap companies typically have substantial economies of scale. From a financing perspective, rating agencies typically provide higher ratings for mega-cap companies enabling them to borrow for less. Size also confers operational advantages. American payment network operator Visa, for instance, is double the size of closest competitor. This enables some mega cap companies to be able to provide lower cost solutions than others.

People. Mega cap companies have the ability to attract and retain talent from smaller organisations, or simply to acquire them along with their market positions and technologies. American company Alphabet, parent company of Google and others, for example is expected to complete the acquisition of Fitbit by the end of the year. In a stroke, the company not only adds 28 million active users and over 5% of the global smartwatch market, but also a successful team.

Liquidity. Shares in mega cap are typically highly liquid. People and institutions regularly trade in these stocks. This results in lower transaction costs as the spread between bid and ask price is low and enables positions to be bought or sold more easily than smaller companies. In “risk-off” environments the relatively lower liquidity in smaller capitalisation stocks can mean that share prices fall more dramatically than they do for larger companies when there are more natural buyers of shares.

Charging elephants are better than dinosaurs 

Not all mega cap companies will make good long term investments. A useful, although perhaps slightly crude analysis, is to separate them into charging elephants and sluggish dinosaurs.

Charging elephants tend to have found business niches which have facilitated growth. Typically, these firms have either generated some form of intellectual property, a product or technology, or have a brand synonymous with quality. The research and development and marketing budgets of the charging elephants makes competing with them a substantial challenge. 

For example, bringing a new single pharmaceutical product through all three phases of clinical trials typically costs upwards of $1 billion with considerable risk of failure along the way. English-Swedish pharmaceutical AstraZeneca has nine such new molecular entities in their late-stage pipeline. Most exciting for AstraZeneca investors however is the huge number of pipeline projects using medicines already approved for different indications and in different combinations. These typically have higher clinical trial success rates than new pharmaceutical products.

Another charging elephant is American technology giant Microsoft.

Over the last twelve months Microsoft spent almost $17.5 billion on research and development. To put this into context there are only slightly over twenty listed software firms in the world with enterprise values over this amount. Or put another way this level of spending, with no takeover premium, is more than the value of over half of the world’s other listed software companies. Microsoft’s products are ubiquitous. Challenging the firm’s dominance in any of a number of fields would require very deep pockets. 

Sluggish dinosaurs include those that began as state-backed entities, and those operating in industries facing major structural headwinds perhaps due to environmental or other social factors. Culture is exceedingly important to how organisations run and can be challenging to change. State backed entities are typically inefficient and are not staffed by entrepreneurial management. This generally makes returns on capital low and growth, outside of any potential government backed monopoly positions, unattractive. 

Being big brings benefits, but while the case for global mega cap investing is strong, bigger isn’t always better. Being focused on the characteristics of quality mega-caps should allow investors in mega cap funds to sleep easily while the companies they own charge on. 

(Note: Unilever, Visa, AstraZeneca, Microsoft and Alphabet are examples of some of the holdings in the Ashburton Global Leaders Fund)