In this letter we put forth our view that receiving premium returns for investments in larger or more complex businesses is not a given. Frankly, this may be one of the simplest ideas or philosophies that comes from our research desk but one that is very important and often ignored by most of the market. The graphic below illustrates the idea.
| ABC Corp. | XYZ, Inc. |
| Revenue: $140m Assets: $125m Market Cap.: $40m Internal business units: 2 Countries operated in: 1 Industry regulation: Low Analyst and media coverage: Low | Revenue: $1,150m Assets: $2,900m Market Cap.: $1,045m Internal business units: 5 Countries operated in: 12 Industry regulation: High Analyst and media coverage: High |
| Purchase price: $3.00 | Purchase price: $30.00 |
| Sell price: $6.00 | Sell price: $60.00 |
| Investment return: 100% | Investment return: 100% |
These representative companies sit on either end of the spectrum and reality is never quite this clear cut. However, it is easy enough to see that the same sized investment in each company over the same time period would yield the exact same investment result despite the outsized complexity, size, and notoriety of XYZ, Inc.
While each company’s differences on paper are easily identified, what is not easily seen is the amount of time it takes to comprehensively understand the entirety of a company well enough to make a high-conviction investment in it. As a research team, we spend a large portion of our time reviewing financial statements, all other public filings, company-specific news, trade publications, and speaking with management for each of the portfolio companies as well as for qualified ideas for new investments. The greater the complexity of a company’s balance sheet, income statement, accounting and reporting methodologies, capital structure, debt terms, or number of SKUs (to name a few things that we consider) the more time must be spent reviewing the company to establish or maintain the highest level of understanding possible, which ultimately results in a high-conviction investment. It is not that larger, more complex companies cannot be understood or that we don’t take the necessary time to understand them when there is a compelling investment opportunity (Kraft Heinz Company and Atlas Corp. come to mind). However, as the graphic illustrated, there is no premium earned on an investment in a more complex business and the additional time spent drilling down on all relevant details of a company ultimately detracts from the time available to review and understand other companies.
Larger, more complex companies also typically bring into play additional volume of business risk factors that must be considered prior to investment and monitored throughout the life of the investment. Examples of risk factors that are increased for larger companies are: foreign currency, additional counterparties, geopolitical, key person, and antitrust considerations, among others. Again, it is not that these factors cannot be understood, but the additional time to understand the issues and monitor them does not translate into a premium return over a similar business of a smaller size. The additional business risks also expose the investment to sensitivity to a wider scope of black swan events. Critics of this way of thinking may propose that a larger business’s own wide-ranging operations make it more internally diversified in the risk factors mentioned. While this may be true for some of the world’s largest enterprises, we manage our investment portfolio’s exposure to each of these factors internally and do not necessarily need the company-specific diversification that can be offered by these conglomerates. However, as always, we remain open for discussion of the concept.
The idea of not receiving a premium for investment in a complex business is primarily based upon the amount of human capital it takes to make a high-conviction investment and the increased number of risk factors that larger businesses are exposed to. That said, there are also other forces at play that make smaller, lesser-known companies more likely to be an investment opportunity that meets our criteria. One of those forces is the lack of coverage both from a sell-side analyst and media perspective. Smaller companies tend to have fewer eyes on them and, consequently, any information that is made public has fewer people reviewing it and propagating an opinion on the company and its appropriate price. Further, there are likely fewer market participants trading the security and providing more opportunities for the market to discover the “true” price. This ultimately makes the market for that security less efficient, which results in a greater likelihood of the security’s price being at odds with our internally developed appraised value (a situation that we take advantage of in our investments). The practical efficiency of today’s markets is a contested issue among academia and practitioners alike, so we don’t seek to resolve that issue in this letter. In the meantime, we will continue to use the discrepancy between today’s price and our appraised price to our clients’ advantage.
As is the case with the concept discussed today, our research team continually discusses the ideas that comprise the bedrock of our research process and constantly discuss new ways to improve both our process and the way we think about companies and markets.
As always, please reach out to MIAM if you are interested in partnering or you would like to discuss a particular company or idea.
Sincerely,
The MIAM Research Team