When corporate expansion comes at a cost

The word ‘growth’ popped up 93 times in Unilever’s (ULVR) third-quarter trading update, even though the document only ran to eight pages. Education giant Pearson (PSON) achieved a similar hit rate, mentioning growth 32 times in three pages, while Relx (REL) managed to cram in 15 references per page.

This FTSE 100 snapshot highlights a truth almost too obvious to state: businesses – even relatively mature ones – are fixated on gains. Whether it is sales, profits, demonstrating their market share, prices or customers, numbers should only be moving in one direction.

But is all growth good? And is bigger really better for investors? In recent years, there have been various companies that, in doggedly going for growth, have undermined their core appeal. Meanwhile, other organisations have become so successful and so huge that further advancements look unlikely.

The winner’s curse 

Rob Arnott, founder and chair of Research Affiliates, has spent a great deal of time thinking about this last point. Just over a decade ago, he published a paper called The Winner’s Curse with his colleague Lillian Wu.

In it, he argued that companies with “top dog” status – defined as the biggest by market capitalisation in each sector or market – have a “statistically significant tendency... to underperform both the overall sector and the stock market as a whole” over long and short periods of time. As such, they are “dismayingly unattractive” to investors.

Arnott identified various reasons for this trend. “When you are number 1, you have a bright bullseye painted on your back,” he said. “Governments and pundits are gunning for you. Competitors and resentful customers are gunning for you.”

He added that top dogs are often overvalued because investors “form biased expectations based on extrapolating past successes that are often not predictive of the future”.

Since Arnott published his report, the world’s largest organisations have got significantly larger. This time 10 years ago, chart-topper Apple (US:APPL) – whose growth prospects are the subject of our cover feature this week – was worth $433bn. Today it is worth $2.65tn. They are also more concentrated. Nineteen of the 20 most valuable companies are now domiciled in the US and the top seven – recently christened the “magnificent seven” – are tech stocks.

There is a growing sense, therefore, that today’s top dogs are on track to become unstoppable monopolies, dominating world indices, killing off potential competitors and pumping colossal sums into research and development.

This has not weakened Arnott’s conviction that the “profound and relentless” rotation at the top will continue, however. In fact, it has strengthened it.

“It would be unsurprising if the top dog effect got more intense in the years ahead,” he tells Investors’ Chronicle. “The regulatory environment in the EU is extremely aggressive. Ordinary business competition is seen as predatory. The US is moving aggressively in that direction.”

Now these companies are so vast, natural slowdowns are also likely, he argues. “As you get bigger, it’s harder to move the needle. If Apple comes out with another innovation as important as the iPhone, it would move the needle, but not as much as when it was smaller.”

Has Big Tech not proved its longevity, though? Apparently not. “When people look at the top dogs today and say ‘Amazon (US:AMZN) Apple, Microsoft (US:MSFT), these were successful companies in the last tech bubble and they have gone up to great heights’, I think ‘yes and no’”, says Arnott. “They existed back then, but only one was in the top 10.”

Corporate blobbishness 

It is not just monster tech stocks that investors need to think carefully about, however. UK large caps – notably absent from the list of the world’s biggest companies – also pose a conundrum.

Unlike the world stage, the FTSE 100 is dominated by mature industries and growth is rarely explosive. Instead, such businesses are thought to be cash-generative, stable and predictable.

It is dangerous to believe the status quo cannot be disrupted, however. The aggressive expansion of Aldi and Lidl, for example, rocked supermarket stalwarts Tesco (TSCO) and J Sainsbury (SBRY) and highlighted the importance of agility and innovation. While it is tempting to assume that organisations will keep reaping cost advantages as they expand and wield ever-greater power, this is not always the case. ‘Diseconomies of scale’ are a threat.

A disconnect between management and frontline production can breed inefficiency or bad behaviour, for example, as can hordes of middle managers (a former chief executive of HSBC (HSBA) famously asked ‘Can I know what every one of 257,000 people is doing? Clearly I can’t’ during a tax evasion scandal).

Diseconomies of scale are a key risk for specialist distributor Diploma (DPLM), which entered the FTSE 100 in August. Diploma’s decentralised model is widely admired, as it encourages entrepreneurialism and accountability among its 20 separately managed firms. Management has recently stepped up its expansion plans, however, and some investors are worried that the dynamic could shift as head office staff multiply.

Wealth Club fund manager Charlie Huggins says the “risks of corporate blobbishness have arguably never been greater” for companies given the levelling effect of the internet. “Smaller players who were previously locked out of stores can take advantage of ‘unlimited’ online shelf space, while the advent of social media offers scope for smaller brands to reach a mass audience quickly and efficiently,” he says.

By contrast, larger players face saturated markets and are forced to take greater risks. The success of Aldi and Lidl, for example, was painfully at odds with Tesco’s own attempts to kick-start growth by opening stores in America, which was an unequivocal disaster.

“We regularly talk about the fact that trying to enter into the US market is really challenging,” says Amisha Chohan, executive director at Quilter Cheviot. “If you look at the US, it’s made up of lots of states that act in different ways. They are almost like mini countries.”

Large caps are ultimately in a difficult position, therefore. On the one hand, they need to find novel ways of sizing up to keep attracting investors. As they do this, however, execution risks pile up, chains of command get tangled, and the threat posed by nimble newcomers intensifies.

Shoal of piranha 

Some companies have spoken frankly about this dilemma. In its half-year results, Next (NXT) said it risked becoming an “unwieldy retail conglomerate that lacks the focus and agility we have worked so hard to maintain over the last 30 years”. At the same time, many of its markets are nearing saturation point, and newer brands such as FatFace, Made.com, Cath Kidston and Joules will “lay the foundations for future growth”.

In a typically reflective mood, Next said that “the history of retail is littered with failed conglomerates” which ultimately succumbed to smaller rivals. “These disruptors, dismissed at first as minnows, become a shoal of piranha and the carcass of the once mighty behemoth is slowly eaten away,” it concluded.

Can Next avoid this fate? Analysts are generally optimistic. They stress, for example, that Next is keeping its new brands creatively separate. “If things become too homogenised you lose what that brand is all about and why you bought it in the first place,” says Peel Hunt analyst John Stevenson. “It’s not necessarily that the scale is too big, but that you take away the essence of the brand.”

At the same time, Next will be able to leverage the scale of its infrastructure to drive operational efficiencies at its new ventures.

This does not always go to plan, of course. Fast-fashion group Boohoo (BOO) reported last month that its ‘label’ brands – consisting of those it has bought over the past five years – saw “more significant revenue declines” than its core products, following the decision “to target more profitable sales”.

Making these brands lucrative was far harder than management expected, as efficiencies of scale failed to materialise because each brand needed lots of separate marketing investment.

Asos (ASC) has experienced similar issues. In its full-year results this month, the online retailer said its “focus on growth without due consideration for the cost” had contributed “significantly” to its destabilised balance sheet and hefty losses.

Growing pains 

In many ways, however, the problems facing Asos and Boohoo are fundamentally different to those facing Next. While Next has achieved impressive stature through organic means, and is only just diversifying, the online players grew extremely quickly, hoovering up external brands to turbocharge their top lines, and lost control of their profit margins. 

This leads us to the final question: are some types of growth best avoided? 

Many companies turn to acquisitions to boost their prospects. Indeed, deals have increased 40-fold over the past 40 years. As we explained in our 10 March cover feature, M&A Masters, this can yield positive results. 

However, a growing body of research argues that M&A often has the opposite effect. The Merger Mystery, published last year by Cambridge economists Geoff Meeks and J Gay Meeks, noted that “statistical studies over the last four decades suggest that, although some mergers are positive-sum, very many do not lead to increased operating profits”.

Investors face a difficult decision, therefore, when presented with acquisition plans – and a lack of information can make things worse. Survey specialist YouGov (YOU), for example, is trying to buy the consumer panel business of GfK for €315mn (£273mn), which it raised via an equity placing. The acquisition would be its biggest to date and is expected to close in the coming months.

The purchase makes strategic sense. It will increase YouGov’s exposure to the fast-moving consumer goods market, for example, which often has significant research budgets. Market research groups rarely come up for sale. 

However, Liberum analyst Andrew Ripper flagged that GfK is a private firm, meaning very little information is actually publicly available. “It makes it quite challenging to get beneath the hood of the business,” he said. Investors, it seems, need a certain level of blind faith in YouGov’s management team. 

Rentokil Initial (RTO) is another useful test case. The pest control specialist bought US group Terminix in October 2022 for a whopping enterprise value of £4.5bn. The deal has massively increased its scale and turbocharged its revenue, making it a fearsome presence in the sector. 

Issues have started to surface, however. Shares dropped by 30 per cent in October after the group reported some weakness in the North American market, with figures coming in “marginally below” previous expectations. This seems an extreme reaction, but investors are clearly hyper alert to execution problems. As Amisha Chohan says, “trying to enter into the US market is really challenging”.

Rentokil’s history also contains a warning. In 1996, it executed a hostile takeover of rival business services group BET, which had significantly higher revenues than Rentokil itself. The deal turned out to be a nightmare: profit targets were missed, the group was split up and shares endured a decade-long descent. 

There is no guarantee that history will repeat itself. Rentokil is certainly a more focused business than it was 25 years ago and the integration plan is still on track. However, the stock market’s memory is often short and the wisest investors should dive into the archives from time to time. The same is true when thinking about stocks that seem unstoppable, dominating industries, indices and public consciousness. Giants can quickly be lost to the passage of time.

While companies often boast of their fast growth and impressive stature, therefore, it is important to remember that bigger is not always better.