The S&P Paradox

Despite all the complex options available, one of the most effective investment strategies has been to simply play the S&P index. I readily complied, with success, without giving much thought to the underlying paradox that was always in the back of my mind.  Large companies are riddled with inefficiency, myopia, and an overall lack of agility; so it seems counterintuitive to bet on them.  I never quite understood why S&P returns were higher than others, because in my mind, bigger is not always better.

For one, scale matters.  In the past, large capital expenditures were required for entry into top industries like automotive, real estate and oil and gas. Even today, most markets still tip to the big players.  In healthcare, size is required to extract better rates from payers. In distribution, size helps gain operating leverage over fixed costs.  In retail, the likes of Amazon and Walmart use it to squeeze unmatched purchasing savings from suppliers. Large companies use its power to build barriers that make it difficult for smaller companies to compete with them. Warren Buffett calls it a "moat".

The numbers don't lie. Over the past 50 years, the S&P 500 has gained 10% a year on a compounded basis compared with 3% for the US GDP over that same period.  Despite what people say about small companies being the "growth engine" and "lifeblood" of the country, large companies have grown more than three times faster than the overall economy over a long period of time. Further, valuations of the S&P have historically been around 15 times earnings (with a current P/E closer to 20), which is at least twice as much as private companies. Simply put, larger enterprises are valued more than smaller ones.

But isn't this counter to what those on the inside of a large company know to be true?  Meetings to discuss meetings. Consultants to develop ten year strategic plans. Steering committees to make even the smallest decisions. Meanwhile, nimble entrepreneurs come up with new products and services, focus on customer service, and find new approaches to enter established markets. At some point, diminishing returns come into play as companies grow.  And in today's market, that size is getting smaller and smaller.

"Moats" are harder and harder to keep, thanks to rapidly deployed technology and more open markets. Uber and AirBnB, for example, are scaring some of the most powerful oligarchies in the world. Further, some of the tailwinds that have been fueling S&P companies such as global gains and consolidation are in the rear view mirror. For years, successful private equity firms have yielded superior returns in the small company space; perhaps there will be a broader movement towards entrepreneurial companies. It is very interesting and hopeful to think about; but no question it will be hard to fight a trend that has withstood the test of time.


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