Is it better to back David or Goliath?

Fixed costs don’t always come down the bigger a company gets – many fast-growing businesses enjoy rising returns that hit a peak then start to drift down.

Larger systems have more complexity than smaller systems, which comes at a cost. The author suggests how to find the sweet spot. Image: Shutterstock

Following on from two categories of businesses that investors should avoid, I want to highlight some businesses models that benefit disproportionately from size.

‘Returns to Scale’ says that due to fixed costs dropping as a percentage of a larger size, larger businesses are more profitable than smaller businesses. While this can be true, in the real world many fast-growing businesses that are enjoying rising returns see these returns peak at some indeterminate size and then start to drift down.



Listen: Global small caps a giant market

The opposing force of Returns to Scale is something called the ‘Complexity Curve’. Larger systems have more complexity than smaller systems, and this comes at a cost.

A business growing from an owner-founder-CEO into a gigantic multi-national sees a multitude of layers of management, boards, lawyers, advisors, bankers and systems installed that all add cost. And eventually the added overheads and costs eat up the Returns to Scale, bringing returns back down.

(At this point, the break-up experts and activist shareholders enter … but that is another article entirely.)


In this way, smaller companies moving up the Returns to Scale curve benefit and larger companies can roll over, giving the smaller companies and their investors ‘alpha’. For this reason – and their typically lower valuations – I and many others like investing (at least somewhat) in smaller capitalisation stocks.

But there are some businesses that benefit disproportionately from being larger, and thus create real barriers to entry for smaller players trying to get in.

In this space, I would be wary of investing in any investment other than the largest few players.

What to consider

The best way to identify the winners of scale is to ask which businesses benefit disproportionately from diversification, yet their business is capital (or time) intensive.

For example, it costs a lot of money to build a mine, and a big mine makes a lot more money than a small mine (Returns to Scale).



Yet a listed company that only owns one mine – big or small – has a significant risk as that single mine could collapse or flood or shut down, shutting off its single source of cash flows.

Thus, there is a significant drop off in risk when we move from a single-mine resource counter up to multi-mine portfolio – and even to multi-mine, multi-commodity and multi-geography global mining houses.

Thus, BHP Group (BHP), Anglo American (AGL) and Glencore (GLN) are all massive beneficiaries of scale that is quite simply hard to replicate.

Similar economics can be found in the oil and gas market where there is a significant drop off in risk when one moves from the single-well/field operators to the globally diversified big oil majors.


Several other industries exhibit this characteristic – from insurance and banking to big pharma and social networks (but not necessarily all tech).

And in most of these instances, I would think long and hard before backing a new upstart rather than just investing in the already derisked, at-scale incumbent. While David can defeat Goliath, in these industries the odds are stacked against him.

Keith McLachlan is chief investment officer at Integral Asset Management.

William Murphy

Related post