UK: HOW BIG? The continuing global rush into ever bigger mergers raises serious questions.

UK: HOW BIG? The continuing global rush into ever bigger mergers raises serious questions. - Is this trend the result of sound strategy or is it driven by ego and greed, or a need to satisfy markets with endless growth? We put the issue to John Kay of Ox

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Last Updated: 31 Aug 2010

Is this trend the result of sound strategy or is it driven by ego and greed, or a need to satisfy markets with endless growth? We put the issue to John Kay of Oxford's Said Business School, who thinks big can be too big, and to McKinsey mergers specialist Lowell Bryan, who contends that if you don't dominate your market, you're history. And only history will decide who was right as the new giants prosper or unravel.

By JOHN KAY and LOWELL BRYAN.

DEAR JOHN, Can a company ever be too big?

I would say no. But let's be clear what we mean by size. Certainly, we'd agree the days are over when physical size alone - a company's asset base, sales, employees, etc - was necessarily good. The fate of the conglomerates at the hands of LBO specialists in the '80s, and Korea's chaebol today, illustrate that.

Nevertheless, traditional 'bigness' - that is book-equity, or asset value - is important. Developed and managed appropriately, there's no amount that's too much. But it's only part of the story. Because the size that really matters is market capitalisation.

As you know, market capitalisation is simply a measure of the value the market places on a company. You need a high market capitalisation to capture globalisation's growth opportunities. Everyone is rushing to capture them and, as the fast way to grow is by acquisition, it's a buying spree. A big market capitalisation makes it cheap for you to buy, and difficult for others to buy you.

Now, a firm's market capitalisation is driven by its physical size and how well it performs (in terms of generating return on capital). Hence, two quite different companies can have similar absolute market capitalisations.

One might be big in terms of physical capital invested, but enjoy only moderate returns. Another might be much smaller, but have a much higher market premium because of superior performance. There's no sense in saying one is 'bigger' than the other. What matters is that they have roughly equal market power.

How much market power do you need in a global economy? Companies that are neither big, nor performing well, are in trouble - vulnerable to takeover by almost anyone. Those that are physically big have some protection, as do those that are small but whose performance compensates. What is important to note is that some asset-laden companies can be vulnerable to companies that are much smaller in physical terms. For example, Worldcom acquired MCI, which was much bigger in terms of its physical size, but whose performance was weaker. MCI had less market power. The only companies that are genuinely in control are those that combine physical size with performance. To reach such a powerful position in a global economy two things count - intangible capital and specialisation. The more you build these things, the bigger your market capitalisation will grow.

Intangible capital means knowledge, brands, relationships, skills, and so on. Specialisation, or focus, is the ability to do something, however narrow, better than everyone else. The market has long rewarded these things to some degree. But globalisation makes three differences. First, global capital markets make it relatively easy for any reputable company to raise capital - big or small. You don't need physical size to be able to attract capital - intangible assets will differentiate you from the competition.

Second, the removal of barriers to geographic competition gives companies access to millions more customers, so they can build a big customer base even if they focus on just some very narrow thing. In addition, if they use intangible capital they can build their customer base relatively cheaply.

Finally, the digital revolution means you can build a business on much narrower specialities. Why? Well, it used not to make sense for a bank to outsource, say, its credit card processing. It was cheaper to do it in-house. Now the marginal costs of interacting with other firms are falling rapidly, enabling specialists to work together far more easily.

I'm simplifying, but this basically means you don't have to do anything you're not really good at anymore - because you can outsource the rest, and build a big business on just what you're good at. Moreover, if you don't specialise, you won't be as good as competitors who do.

So the market rewards those specialising in areas where they have an intangible capital advantage, because this enables them to earn high returns on the physical capital they do invest. In effect, these companies end up earning more using less, and their market capitalisation skyrockets.

To increase it still further, the trick is to replicate success by operating in more than one specialism, thus increasing your size without lowering returns. Of course, if you stray into an area where you don't have strong intangible capital, you're headed down the path of the old conglomerates.

But as long as your size is built upon intangible capital, you can never be too big.

Well, you won't be surprised I'm interested to hear your thoughts!!!

BEST, LOWELL BRYAN

DEAR LOWELL, Can a company ever be too big?

Well of course you can't be too big if the reason you got to be big was that people just wouldn't stop buying your products. That is most of the explanation of how IBM, Microsoft, Coca-Cola and Disney got to be big, and it's why these have been some of the most successful companies of the century. No one would suggest they should have stayed small by turning their happy customers away.

Nor can you be too big if size is measured by market capitalisation, and what drives your size is the value the market attaches to your shares. That's what makes Yahoo!, Amazon and Worldcom big, and while we might be worried as investors by these dizzy Wall Street ratings, they can't be bad for the companies themselves or the people in them. No one would suggest that these companies should have stayed small by discouraging people from buying their stock.

But the pursuit of size and scale today is not about the pursuit of market success, either in satisfying customers or investors. You say that the days when enormous physical size was by definition a good thing are over.

If I disagree, it is only because I believe there never were days when enormous physical size was by definition a good thing. But even if you and I agree on this, the message hasn't yet got over to many of today's chief executives. When BP merged with Amoco, Citigroup with Travellers, or Ciba with Sandoz, they were concerned precisely to enlarge the company's asset base, sales and number of employees. As you say, everyone is rushing to grow through acquisition. And today's question is, indeed, are you going to buy or be swallowed up?

Tomorrow's question, on the other hand, is whether any of this makes sense. Is today's merger frenzy generated by some genuine change in underlying logic which makes ever bigger corporations necessary?

Not necessary in order to secure self-protection in a world of self-destruction, but necessary in order to perform the real functions of business - to serve customers better and in doing so make money for investors.

Or is this wave of acquisition simply the product of the ambitions of chief executives and their investment bankers' need for transaction fees? And will the next decade see the unwinding of many of the most spectacular acquisitions - as happened to the conglomerate mergers of the 1970s and the asset plays of the '80s?

These are the questions that you and your more thoughtful clients should be trying to tackle. And let me help by offering some of the answers.

It is very rare for the market power and scale economies associated with market dominance not ultimately to fall victim to the hubris, insulation from the market, and sheer bureaucratic inefficiency that goes with that size.

Look at US Steel, the largest industrial company in the world at the beginning of the century. It was created on the basis of arguments uncannily familiar today: the inevitability of concentration and rationalisation, the opportunities for cost saving and the exercise of market power. Today it is a shadow of its former self.

Or Distillers, formed in 1926 by the amalgamation of almost all the major Scotch whisky producers, to begin a 60-year record of ineluctable decline.

Or look at IBM, or General Motors.

Who would look at these examples and doubt that companies can be too big for the long-term health of the businesses within them? Not my company, of course, or yours - we know we can enjoy the benefits of size while escaping the disadvantages. But everyone else's company. YOURS, JOHN KAY.

DEAR JOHN,

Thanks for your provocative reply!

I see there is much on which we agree. But let me speak directly to where we might differ. You believe today's merger frenzy is generated more by the egos of chief executives than the needs of the business. There may be some big egos out there - but by and large I can't agree with you.

First, the consolidation under way is different from the conglomerate mergers of the 1970s. BP/Amoco, which you appear to deplore, isn't like ITT's amalgamation of many very different businesses, or the unsynergistic holdings of a Korean chaebol. Many companies these days are growing by acquiring players in or close to their core business, which means they understand the businesses they are acquiring and there's plenty of room for increased efficiency. There's no reason to suppose they will go the way of the conglomerates.

Second, (and here you might agree), the globalisation-related changes I mentioned previously (easier capital, increased access through deregulation and liberalisation, and so on), make it easier to build and manage bigger businesses faster and with less bureaucracy than before. Less bureaucracy means staying closer to the market, and the vastly-greater speed with which new challengers emerge ought to do something for the hubris, too!

So it seems to me the three things you believe bring big players down are less likely to operate this time around.

Third, many of today's large acquisitions will probably be followed by divestitures. Today's marketplace is so dynamic that companies will constantly have to decide where to compete and where not to. The acid test is not whether an acquisition is large or small, but whether or not the company's market capitalisation continues to grow. Large acquisitions are simply an inevitable economic response to moving to a more integrated, global economy.

Finally, as the Dow looks back on the 10,000 threshold, I might note that the market doesn't appear to be troubled by the trend!

Back in your court, BEST, LOWELL

DEAR LOWELL,

It is said that the five most expensive words in investment are 'it is different this time'. You argue that this wave of consolidation is different, and even if others were largely misconceived, this one will pay off. This is what has been said in every other wave of consolidation.

Now it might really be different this time. You point to two reasons.

One is the information technology revolution, which enables chief executives to gain real-time information about everything that is happening in their business.

But not quite everything. Back in the 1960s, many people believed that IT developments meant that companies would soon be run by computers. Having established this in the Ford Motor Company, Robert McNamara went on to implement it in the Defense Department. But Ford, divorced from its customers, was driven out of its markets by the Japanese, and the US army was driven out of Vietnam by the Vietcong. The key information for running a company, or a war, is not the information you get from the internet, but the information you get from talking. It's the people, stupid.

And then you say that, whatever you and I think, the ever-rising stock market proves that the conventional wisdom must be right. I'm sorry, it only proves that it's the conventional wisdom. Your job as consultant - and mine as academic - is to appraise the conventional wisdom critically, not to repeat it. JOHN

DEAR JOHN,

Well, I've not worked at Ford, but I did serve in Vietnam. And like many who've been on active duty, I know that the picture seen by the High Command can look dangerously different from the facts on the ground.

But I'm not convinced by your analogy. The information you get from talking is key: Robert McNamara himself said recently in the New York Times that the Vietnam war might have ended sooner if the two sides had taken the opportunity to talk directly to each other. But the information traversing the internet is talk (including this conversation, conducted entirely by e-mail ), as is the information travelling through corporations' computer networks. The evolution of IT has taken many levels out of our big corporations, so the front line can communicate much more easily with the CEO. This, taken together with the fact that the big mergers are broadening across businesses in a way that will not compromise their focus, does mean that even very big companies aren't very likely to lose sight of customers' needs.

So I guess I do think it's different this time. In the matter of the stock market, I rather think you are trying to have it both ways: you worry that 'bigness' will make decision-makers deaf to the front line, then deride the stock market as mere conventional wisdom. But isn't the stock market the ultimate front line?

But let that go. Say we dismiss the evidence of the stock market. In a world where technology and deregulation give companies access to much bigger markets, they can build enormous businesses on a relatively narrow focus. No one is saying companies can be infinitely large - but doesn't it follow they can be much bigger than they have been in the past? REGARDS, LOWELL

DEAR LOWELL,

We agree that, in managing businesses, information that is qualitative and tacit - the sort of information you get from looking people in the eye, the knowledge that is embedded in the organisation rather than enshrined in the rule book - is at least as important as information that is quantitative or easy to write down. And of course it's the latter, not the former, that modern information technology helps to disseminate.

You say, and in a sense it's true, that the information traversing the internet is talk. But you know also that an AOL chatroom is a pretty sad kind of personal interaction. And I don't think you really believe that the Vietnam war would have been conducted substantially differently if front-line troops, or the Vietnamese people themselves, had been in direct e-mail contact with Robert McNamara and the White House.

Failures of communication were fundamental to the disaster that ensued in Vietnam, but they weren't communication failures of that kind. And the same is true of communication failures in business.

But isn't the stock market the ultimate front line, you ask?

I don't think so: the front line of business is the place where you meet, or fail to meet, the needs of your customers. The stock market is the communications centre, the place you keep score - and as you say from your Vietnam experience, the High Command may see things differently from the folks on the ground.

So, I concede, the stock market is saying 'it's different this time'.

Indeed the Dow Jones has gone from 10,000 to 11,000 in the course of this correspondence. If it goes on rising like that, it really will have been different this time, and - as many investors really believe - the old laws of business and economics will truly have been repealed. But I doubt it.

Time will tell which of us is right. JOHN KAY

CAN A COMPANY BE TOO BIG? MT CANVASSED LEADING PLAYERS

Nigel Stapleton, Reed Elsevier The City has applauded most recent mega-mergers with a significant re-rating in the share price of the companies involved. But one must question whether the City reaction is taking too short-term a perspective.

Guy Hands, Nomura It 's not a question of numbers. Whether a company is 50 or 50,000 strong is irrelevant. What is important is that management understands what is going on in the business and provides appropriate leadership, and that employees feel empowered and connected.

Tim Waterstone, hmvmedia There is nothing inherently wrong in size, but there is most definitely something wrong in lack of focus. Big, focused, specialist companies work OK provided they organise themselves into small cells with minimal central control or interference. Keep your teams tiny. And give them power.

Danny Rosenkranz, BOC Companies growing very large do face significant risk. An organisation can, for example, become so big that it spends too much time talking to itself and insufficient time communicating with its customers.

John Connolly, Deloitte & Touche We have to be wherever our clients are, or want to be. That's why size is vital for a professional-services firm.

Julia Cleverdon, chief executive officer, Business in the Community The key to the successful growth of a company is its ability to integrate socially responsible activities as part of mainstream business practice. Companies are facing challenges on a number of fronts, including reputation management, employee development, diversity in the workplace and stakeholder dialogue. Ensuring that these components are brought together signals the difference between companies that can sustain their growth and those that cannot.

Richard Branson, Virgin I believe companies can get too big, and have always had the philosophy of developing each Virgin business separately, with its own management team who are then focused completely on their own marketplace.

Bob Scott, CGU In pure market capitalisation terms, the answer is no. Nonetheless, evidence shows that size in itself without focus doesn't work - both ICI and Hanson had size but some would say that they didn't have focused scale.

Charles Brady, AMVESCAP The markets we are dealing with are becoming larger and more globalised and these trends will continue. Where increasing scale starts to lead to diminishing returns, then shareholders are likely to vote with their feet.

Anita Roddick, Body Shop Corporate giantism, based on a mechanistic hierarchy, divorces people from the consequences of their actions. That's when you start to see companies acting without regard for human rights or the environment. By that point, the size of the company is damaging not only to itself but also to the world around it.

Baron Buysse, Vickers History has proven that big companies can easily be managed provided that the top team is inspiring a constant change process throughout the organisation, monitoring the key performance ratios in the individual businesses on a regular basis, and taking swift and effective action when necessary.

David Varney, BG To coin a popular phrase, 'Size isn't everything.' Indeed, if I look at the nature of the modern, networked knowledge-based organisation of today, I can't help feeling that size is irrelevant.

John Stewart, Woolwich Current thinking in banking is that consolidation will continue - with big being self-evidently good. However, many banks are change resistant and not consumer responsive. I would not assume being big will be enough for them to prosper.

Peter Ellwood, Lloyds TSB If you are big, you are in a more competitive position, but your management must be capable of handling the complexities that size brings. If your management is ineffective, a major opportunity can instead become a major problem.

John Neill, Unipart It's a function of the human condition that we are dissatisfied with the status quo and always look to something different. 'Big is beautiful' was replaced by 'small is beautiful'. It seems as if we are back in the 'big is beautiful' stage, but the fashion will change.

David Thomas, Whitbread A company can only be too big for its leadership. While there are many very large companies that continue to grow successfully, some seem to take a step too far and lose their sense of direction.

Martin Sorrell, WPP Every company that is ambitious wants to dominate its industry, and therefore become very large. At the same time every chairman and CEO is worried about size and resultant lack of speed of response, bureaucracy, arrogance and complacency. As a result all companies want the power of size and the entrepreneurial spirit and motivation of a small company.

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