Too big to succeed

Chris Dillow

Chris Dillow

Tesco’s profit warning this week highlights a basic but much under-rated idea in economics – diseconomies of scale, or the tendency for larger firms to become inefficient.

There are several ways in which such diseconomies operate. In big firms, managers can’t oversee their underlings well but introducing layers of management creates extra costs and generates office politics and rent-seeking. And in big organizations, managers are apt to lose contact with day-to-day shopfloor reality. Those shareholders who accused the Tesco board of madness and arrogance at its recent AGM were echoing a point made by the great Kenneth Boulding back in 1966 – that bosses of large organizations will often “be operating in purely imaginary worlds.” What’s more, in bigger firms, both workers and – importantly in Tesco’s case – customers lose their loyalty to the company.

You might reply here: if such diseconomies are so important, why do firms become so big in the first place? The answer is that very few do. There are 2.17 million businesses in the UK. Only one per cent of these have more than 100 employees, and only 0.1 per cent have more than 1000. Of course, diseconomies of scale aren’t the only reason why firms don’t grow –some owners don’t want to expand, and others are constrained by operating in niche markets – but these numbers tell us that diseconomies of scale can bite hard.

What’s more, most of the tiny minority of firms that do grow cease to stay big. Howard Gospel and Martin Fiedler, two German economic historians, have compiled a list of the UK’s 100 biggest firms in 1907. Only three of those – Royal Mail, Prudential and GKN – are independent FTSE 100 companies today. Diseconomies of scale – not least of which is the inability to respond quickly to new competitors or to technical change – will get most firms in the end.

Worse still, it is almost impossible to spot in advance the few firms that can escape diseconomies of scale. Granted, we know that some do so because the size distribution of firms doesn’t much change over time so that falling giants are replaced by new giants. But this knowledge doesn’t help us pick winners. “Over long horizons there is little forecastability in earnings” concluded Louis Chan, Jason Karceski and Josef Lakonishok is one study. And Alex Coad at the University of Sussex has found that a huge proportion of corporate growth is random. And not only can we not foresee growth, we cannot foree failure either. Paul Ormerod and Bridget Rosewell at Volterra Consulting have shown that the demise of firms is largely unpredictable.

I say all this because investors have for years not appreciated it sufficiently. So-called growth stocks have under-performed for years. For example, in the last 25 years the FTSE low yield index has under-performed the high yield index by 2.5 percentage points. This is especially striking because long-term interest rates have fallen a lot in this time, which should have caused growth stocks to do better. That they have not done so is consistent with investors over-estimating the potential for growth – or, if you prefer, under-estimating the barriers to growth imposed by diseconomies of scale.

Personally, I would infer from this that there is a strong case for holding tracker funds, because these save one from the wild goose chase of trying to spot future growth. But if you don’t want to go that far, at least remember to be very, very wary of paying extra for “growth” stocks. A concept as simple as diseconomies of scale is more important for investors than generally supposed.

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