Dear John,

Can a company ever be too big? I would say, no.

But let us be clear what we mean by size. Certainly, we would agree that the days when physical size alone (as represented by a company’s asset base, sales, number of employees, and so on) was necessarily good are over. The fate of conglomerates at the hands of leveraged buyout specialists in the 1980s and of South Korea’s chaebol today illustrates that.

Nevertheless, traditional "bigness"—that is, book equity or asset value—is important. Developed and managed appropriately, no amount is too much. But this is only part of the story, because the size that really matters is market capitalization.

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

Now, a firm’s market capitalization is driven by its physical size and how well it performs in the market in generating returns on capital. Hence, two quite different companies can have similar absolute market capitalizations. One might be big (as measured by physical capital invested) but enjoy only moderate returns. Another might be much smaller but win a higher market premium because of superior performance. There is 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 for this; the high market capitalizations of some software companies are a case in point. What is important to note is that some asset-laden companies can be vulnerable to companies that are much smaller in physical terms. WorldCom, for example, acquired MCI, which was bigger as measured by physical size but weaker in performance. MCI had less market power.

The only companies 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 specialization. The more you build these things, the bigger your market capitalization will grow.

Intangible capital means knowledge, brands, relationships, skills, and so on. Specialization, 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 globalization makes three differences. First, global capital markets make it relatively easy for any reputable company—big or small—to raise capital. You no longer need physical size to attract capital, and the advantage of size is therefore diminished. What will differentiate you from the competition is intangible assets.

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

Finally, the digital revolution means that you can build a business on much narrower specialties. 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, even if the bank wasn’t great at the job. Now the marginal costs of interacting with other firms are falling rapidly, enabling specialists to work together more easily.

I’m simplifying, but basically this means that you don’t have to do anything you are not really good at any more, because you can build a big business just on what you’re good at and outsource the rest. And if you don’t specialize, you won’t be as good as competitors that do.

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

To raise them still further, the trick is to replicate success by operating in more than one specialty, thus increasing size without lowering returns. Of course, if you stray into an area where you don’t have strong intangible capital, you are 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 that I’m interested to hear your thoughts on this.

Best,
Lowell

Dear Lowell,

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

Nor can you be too big if size is measured by market capitalization and what drives your size is the value the market attaches to your shares. That is what makes Yahoo!, Amazon.com, and WorldCom big. While as investors we might be worried by these dizzy Wall Street ratings, the ratings 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 stock in them.

But the pursuit of size and scale today is not about the pursuit of market success in satisfying either 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, Citicorp with Travelers, and Ciba with Sandoz, the concern was precisely to enlarge those companies’ asset bases, sales, and numbers of employees. As you say, everyone is rushing to grow through acquisitions. And today’s question is indeed, are you going to buy or be swallowed up?

Tomorrow’s question, however, is whether any of this makes sense. Is today’s merger frenzy generated by some genuine change that makes ever bigger corporations necessary—necessary not to secure self-protection in a world of self-destruction but to perform the real functions of business: to serve customers better and, in doing so, make money for investors? Or is this wave of acquisitions simply the product of the ambitions of chief executives and of the need of investment bankers for transaction fees? And will the next decade see the unwinding of many of the most spectacular acquisitions, as happened earlier to the conglomerate mergers of the 1970s and to the asset plays of the 1980s?

These are the questions that you and your more thoughtful clients should be trying to tackle. Let me help by offering some answers. It is rare for the market power and scale economies associated with market dominance not ultimately to fall victim to the hubris, the insulation from the market, and the sheer bureaucratic inefficiency that goes with such size. Look at U.S. 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 rationalization, the opportunities for cost savings, and the exercise of market power. Today, the company is a shadow of its former self. Or look at Distillers—formed in 1926 by the amalgamation of almost all of the leading Scotch whisky producers and destined to suffer a 60-year decline—or IBM, or General Motors.

Who could 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

Dear John,

Thanks for your provocative reply! I see there is much on which we agree, but let me address directly areas where we might differ. Obviously, you believe that today’s merger frenzy is generated more by the egos of chief executives than by the needs of businesses. There may be some big egos out there, but by and large I can’t really agree with you.

First, the consolidation under way is entirely different from the conglomerate mergers of the 1970s. The BP and Amoco deal, which you appear to deplore, more closely resembles WorldCom’s acquisition of MCI than, say, ITT’s amalgamation of many very different businesses or the "unsynergistic" holdings of a South Korean chaebol. That is to say, most companies are growing by acquiring players in or close to their core businesses, which means that they understand the businesses they are acquiring and that there is plenty of room for increased efficiency. So there is no reason to suppose they will go the way of the conglomerates.

Second, we should recognize (and you might agree) that because of the globalization-related changes I mentioned in my previous note—easier capital, vastly increased access through deregulation and liberalization, the digital revolution—it is easier to build and manage bigger businesses faster and with less bureaucracy than it used to be. 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 you deplore. So it seems to me that the three factors you believe bring big players down are less likely to be operating this time around.

You offer IBM and General Motors as examples of companies humbled by their size. IBM certainly went through a challenging period, but the decision not to break the company up into three entities has been handsomely vindicated, and it is now an excellent example of a very large company getting much synergistic value from intelligently related businesses. And General Motors has done an awful lot better than dozens of smaller car companies that have disappeared or been acquired because they simply weren’t big enough to survive.

Finally, as the Dow crosses the 10,000 threshold, I might note that the stock market does not appear to be troubled by the trend.

Back in your court, I suppose!

Best,
Lowell

Dear Lowell,

It is said that the four most expensive words in investment are, "It’s different this time." You argue that this wave of consolidation is different and that even if earlier mergers were largely misconceived, the present wave will pay off. This is what has been said during 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 businesses.

Not quite everything, however. Back in the 1960s, many people believed that information technology developments meant that companies would soon be run by computers. Having established this at Ford, Robert McNamara,¹ went on to implement it in the US 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 computers but the information you get from talking. It is 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 proves only that this is the conventional wisdom. Your job as a consultant, and mine as an academic, is to appraise the conventional wisdom critically, not to repeat it.

Yours,
John

Dear John,

Well, I have not worked at Ford, but I did serve in Vietnam. I know that the picture seen by the high command can be dangerously different from the facts on the ground.

But I’m not convinced by your analogy. The information you get from talking is essential: Robert McNamara himself said, 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—including this conversation, conducted entirely by e-mail—is talk, like the information traveling through corporations’ computer networks.

The evolution of information technology has taken many levels out of our big corporations, so the front line can communicate more easily with the CEO. This, together with the fact that big mergers are happening in a way that doesn’t compromise focus, means that even very large companies are not likely to lose sight of customers’ needs.

So I guess I do think it is 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 and 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, those companies can build enormous businesses on a relatively narrow focus. No one is saying they can be infinitely large, but doesn’t it follow that 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 you get from looking people in the eye, the sort that is embedded in the organization 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 is the latter, not the former, that modern information technology helps to disseminate.

You say—and in a sense it is true—that the information traversing the Internet is talk. But you also know that an America Online chat room is a pretty sad kind of personal interaction. And I don’t think you really believe that the Vietnam War would have been conducted much 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 were not communications failures of that kind. And the same is true of communications failures in business.

You ask if the stock market isn’t the ultimate front line. 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 center, 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 that the stock market is saying, "It is different this time." Indeed, the Dow Jones has gone from 10,000 to 11,000 in the course of this correspondence. If the Dow goes on rising like that, things really will have been different this time, and, as many investors 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