The old adage that slow and steady wins the race doesn’t seem to fit the realities of the cutthroat competition characteristic of American technology firms. But neither does the commonplace idea that smaller, nimbler and more innovative startups will eventually overtake their bigger, clunkier and less dynamic rivals. That might have been true a quarter century ago, but today’s big corporations are no longer succumbing to the debilitating effects of old age, and small firms are having trouble just reaching maturity, according to data presented in a recent article in the Harvard Business Review.
As recently as the mid-1990s, that old model has begun to break down. Big firms are maintaining their dominance and they are doing so through increased spending on research and development (R&D), the primary driver of an enterprise’s growth and performance, according to Dartmouth Professor of Management Vijay Govindarajan, NYU Professor of Accounting and Finance Baruch Lev, and University of Calgary Associate Professors of Business Anup Srivastava and Luminita Enache.
What It Means for Investors
The traditional idea was that as firms reach a more mature stage of their life cycle they would then focus more of their time and energy on standardizing processes to maximize operational efficiencies and would hand over a greater amount of their profits to shareholders. Startups, by contrast, are supposed to be dynamic, not standardized, and aren’t expected to be profitable as their focus on growth and coming up with the next must-have product or service requires plunging more cash than they earn into R&D.
This model that contrasts the priorities of firms at different stages of their lifecycle has been used to explain why, although inventing most of the technologies used in personal computing today, Xerox Holdings Corp. (XRX) is not one of the largest computing companies. Or why the inventor of the digital camera, Eastman Kodak Co. (KODK), had to file for bankruptcy in 2012, and why Nokia Corp. (NOK; ADR), an early pioneer of the smartphone, ended up losing significant market share to Apple Inc. (AAPL) and its iPhone, according to Forbes.
However, over the last 25 years, that model has grown increasingly tenuous. The difference between the median market values of the largest public firms (top 30% based on market value of equity) and those of the smallest public firms (bottom 30%) widened to $3.5 billion in 1981 dollars (or $8.4 billion in 2017 dollars). From 1981 to the mid-1990s, that gap remained between $0.3 billion and $0.6 billion. The widening gap is not only because of stronger performance from the big firms, but also stagnation amongst their smaller rivals.
The “small size trap” is the label the authors are using to describe the recent difficulty that small firms are having in their attempts to grow into mid-size companies or large corporations. Before 2000, around 15% to 20% of small companies were able to make the size jump, but the percentage doing so by 2017 was cut in half. Meanwhile, the percentage of large companies that have been able to maintain their size status has increased from 75-80% before 2000 to 89% more recently.
On a profitability basis, large companies are also outperforming smaller companies by wider and wider margins. The difference in the median return on operating assets between large and small firms in the 1990s was 15%. Since then, the gap has doubled to around 30-35%. From 2015 to 2017, both the median return on operating assets and median profit margin turned negative for small firms. In terms of annual losses, just 10-15% of large companies have reported negative earnings in recent years, while a whopping 60-65% of their smaller competitors did so.
One of the major noticeable differences driving the growing wedge between big and small firms is the increasing gap in the R&D spend between the two groups. That gap has grown from less than $20 million in the 1980s to nearly $120 million in 2017 (in inflation adjusted 1981 dollars). With large firms spending an average $330 million on R&D in 2017 versus an average of just $6 million for small firms, the ability to be innovative appears to be reserved for an exclusive club of big spenders.
One of the reasons monopolistic firms are supposed to be bad is that the lack of competition reduces their incentive to innovate, resulting in a stagnant economy. But while there may be good reasons to be concerned about the dominant size of big tech companies like Amazon.com Inc. (AMZN), Facebook Inc. (FB), Alphabet Inc. (GOOGL), and Apple, all of which are now facing regulatory scrutiny, the recent findings highlighted above suggest that lack of innovation isn’t one of them.