When big is not beautiful

The following article appeared in the Australian Financial Review on June 04, 2018.

It’s tempting to confuse large with robust. Footballer Buddy Franklin is large, and he looks pretty robust. Same with the Harbour Bridge. Then again, so were Goliath, Lehman Brothers and the Titanic.

I’m not suggesting that the bridge or Buddy aren’t sturdy or made of steel. Size introduces its own risks, though. As former trader and philosopher Nassim Taleb enthusiastically advocates in his book Antifragile, increasing complexity exponentially increases the number of points of failure.

It’s easy to identify such risks in hindsight but far more difficult in the present. For example, few investors outside of chronic Chicken Littles correctly predicted the global financial crisis. I certainly didn’t.

Still, examples of large-scale fragile situations abound. Take Italian bonds, which recently suffered their worst day in at least 25 years. Even after a disastrous turn of events and despite vast political and economic uncertainty, though, the yield on 10-year Italian bonds is only a paltry 3.2 per cent.

Examples closer to home aren’t difficult to find either. If you want to look in the rear-view mirror, you’ll see Telstra and BHP Billiton. Telstra’s shareholders, many of whom bought the shares for a yield that was around 5 per cent a year ago, have suffered a 37 per cent capital loss as competition has picked up. The company’s high payout ratio and big debt load haven’t left much wriggle room for the business either, at least without not some painful choices.

Or take the country’s big miners. Yes, the worst of the most recent boom-and-bust cycle may be behind them, but it also underscored the fragility of their price-taking business models despite their prodigious size and world-class execution.

Bank risks

How about a current example? Take Australia’s big banks. They each have total assets of around 14 to 16 times their equity base, lending practices that haven’t been battle-tested in a generation, and most or much of their loan books in residential mortgages at a time when property prices are cooling off.

As if that concoction does not introduce enough tail risk, the big banks also have regulators breathing down their necks and valuations that, despite having pulled back, could hardly be considered cheap in the context of book values and global peers. Also, like Telstra, the big banks have lofty payout ratios that would leave dividends under pressure in the event of a recession.

Again, much like I’m not predicting an untimely fate for Buddy or the bridge, I’m not predicting disaster for Australia’s big banks. Nonetheless, it would be naïve not to acknowledge that the concoction of size and considerable leverage is not combustible, particularly when key variables such as interest rates and home prices aren’t within the bank’s control.

A simple way to invert many of the risks that face even large companies is to seek out businesses with strong balances and pricing power that has not been flexed to obnoxious levels.

Another – and this is getting back to the matter of bigger size boosting risk – is to seek out businesses with increasing returns to scale. Namely, businesses with network effects.

Unfortunately, not too many businesses tick these boxes, particularly within a single market. Looking abroad and zooming out, though, examples come into view: Booking and PayPal.

The two US-listed companies each become fundamentally and exponentially stronger with each incremental node to their networks and are fiscally fit with strong balance sheets and wide profit margins. That’s not to say they’re recommendations, simply to say that such rare beasts exist.

What I can recommend, though, is that investors of all stripes keep their eyes peeled for icebergs that could breach the hulls of even large companies. And the greater the debt, size, and competition, the more likely investors are to find themselves tossed overboard.

Joe Magyer is the chief investment officer of Lakehouse Capital. Magyer owns shares of PayPal. The Lakehouse Global Growth Fund owns shares of Booking and PayPal. This article contains general investment advice only (under AFSL 400691).