This is not quite a follow-up article, but it is an extension of my thoughts in “Scale’s is a Two-edged Blade”.
My argument that scale can come with problems may be interesting, but is it accurate?
Anecdotally, we know that you cannot choose which stock to invest in based purely on the size of the company. We know that investing is not that easy.
But can we prove it?
I have built a series of correlation coefficients between the ALSI’s various listed companies stock total returns. I have done this over 5 year and 10 year periods, where applicable. I have excluded those stocks without 10 years of history, though, just to make things more meaningful and the different 5 and 10 year time periods depend on the data availability.
My point, though, was to use sufficient time-based data that one can hopefully minimize the distortions of economic cycles from the results (i.e. sectors and industries that rise and fall based on macro-events) and zoom in on the key metrics that affect companies.
Here is my summarized result (click on the graph to expand it):
Sources: Bloomberg, my workings and assumptions
Firstly, while size is mildly correlated to returns in the long-term, it is not a very strong one. Also, one needs to separate correlation from causation. It may not be that large companies have a mildly positive correlation to higher returns, but that higher returning companies tend to grow into large companies. I would hazard a guess that the latter is correct, but this shallow study does not go as far as to prove that.
Either way, size not very statistically relevant for investment decisions.
Secondly, here are some auxiliary observations that I find quite interesting:
- 5-year total return: I compared 5 year total returns of each stock to their 10-year total returns. Interestingly, this is the single highest correlation of all metrics. Winners tend to stay winners, and good businesses tend to remain good businesses. I will touch more on this later.
- Sales growth: Sales are a function of size, or, at least, size is a function of sales. There was an interestingly low correlation between sales and returns, thus implying that the majority of listed companies pursue size and turnover at the expense of returns. Empire building is the result and low returns are the symptom of this.
- Price Earnings (PE): A very strong correlation here. Interestingly, the same thing run with EV/EBITDA had only a 0.11 correlation… I am not sure what this means, but perhaps it is telling us that valuations are key in returns, but are decidedly complex and not captured by one single metric.
- ROE and ROCE: All reasonably strong correlations between a companies profitability, as I would expect. View these metrics much like a bank account’s interest rate. The higher the interest rate, the faster the money in the bank account compounds the greater the value of the investment at any future time.
One could say plenty more on this subject, but for sake of brevity, I will close on what I feel is the most interesting observation: winners tend to stay winners.
Am I arguing for momentum in investing?
Personally, I dislike that view of markets. It implies that our financial systems and markets operate under Newtonian Equations of Motion, much like the majority of the physical world. They don’t. Markets are a weird concoction of financial logic and human psychology.
That said, the more I think of the correlation of 5-year and 10-year returns to each other, the more sense it makes to me.
A good business with great barriers to entry for new competitors, compelling competitive advantages over peers and fantastic systems, structures and capital allocations, tends to stay that way. These tend to be fairly permanent fixtures in a business model and its operations and, especially if they are working so well, managers and Boards tend not to change them. In fact, if anything, they tend to lean into them and drive their expansion.
Let me phrase it this way, the highest returning on stocks over 10 years in this analysis was Capitec (CPI), Naspers (NPN), and Coronation (CML). Capitec doesn’t wake up one morning and decide that it is going to radically change its lending policies or decentralise its low-cost ICT functions. Tencent doesn’t wake up one morning and realize that they have lost every single one of the billions of users it has amassed in its rich ecosystem. Likewise, Coronation doesn’t wake up one morning and decide to change how it runs its funds or that it is going into insurance or other financial services.
While barriers to entry can change with legislation and technology and competitive advantages can get eroded over time, good businesses tend to stay good businesses (at least in the medium-term).
Maybe a topic for another article, but I would also venture that the opposite is also true. Bad businesses tend to stay bad businesses.
Perhaps that is the lesson here and not one about size. After all, in my opinion, size is likely the result of being a “good business” for a “long time”. Returns to investors over the course of this period are just a by-product of this.