RCM Managed Asset Portfolio - Smalls Caps and Large Caps: The Distribution Systems Have Changed

Smalls Caps and Large Caps: The Distribution Systems Have Changed

Last month we discussed why large caps have been outperforming small caps since 2005 and that part of the causes had to do with the construction of the market indices. This month we will discuss why large companies may have inherent advantages over small companies, which did not exist prior to 2005. What is so important about 2005? That was the first full year of Google operating as a public company and two years later, after the acquisition of Double-Click, it was transformed into an advertising powerhouse. 2005 marked the beginning of a new distribution system for reaching customers.

The Old Distribution System

The way a lot of companies in America grow is through a combination of new products and distribution. If a company has a new product, it needs to get it into the hands of customers who have not tried it. Sometimes these are customers of their old products, but if a company is to grow, it will often be through customers who have never tried any of their products before. Before the Internet, the challenge of reaching customers was primarily geographic. The only way to get new products into the hands of new customers was either to open more stores or to use someone else’s stores. Examples of the former included the rise of restaurant chains, not only McDonalds, to use an obvious example, but restaurants like Applebee’s, Chilli’s and TGIFs in the 1980s and 90s. Examples of the latter included Nike, which for the most part doesn’t have physical stores, but their product helped grow the store footprint of Foot Locker and other athletic goods stores.

In those cases, it was easy to figure out what the growth rate of a retail company could be. If the retail concept was successful in one part of the country, the growth rate would approximate the grown rate of new stores in other parts of the country. Oftentimes, the company would tell investors what their plans were—how many stores they wanted to open in x number of years. 

What the retail company was doing was taking advantage of the infrastructure that had been built out decades earlier through the interstate highway system, which allowed for America’s population to grow in new places. This geographical spread manifested not only in the retail growth but also in other industries such as airlines. Southwest Airlines was growing its routes, just as Wal-Mart was growing its stores. And you could gauge Southwest Airlines’ 

sales growth by the rate of routes it grew out from its early beginnings in Love Field, Dallas. Whether retail or travel, the challenge of distribution was the challenge of geography, providing a product to places where it had not been present before.

But with the rise of the Internet in the period since 2005, distribution to customers became more of an online affair so much so that I, as a portfolio manager, realized in the early 2010s that I could no longer rely on this method of counting store growth to model revenue growth. There are only a few kinds of retail businesses now where store growth is still significant. These are businesses where you need to go to the store to get the service—such as Ulta Salons—or where it is burdensome for the store to deliver the heavy goods like with Home Depot. Even restaurant concepts are no longer immune to the Internet as the difficulty of providing service is being lessened with food delivery and online ordering.  Now everyone pursues a “multi-channel model” of reaching the consumer—not just the physical location or others’ distribution channels but also direct-to-consumer online.

Online is the New Distribution System

All of this is to point out that the point of distribution to reach customers is no longer predominantly growth through geography but instead increasing the number of users you can reach online. The users themselves and their presence online have become the point of distribution for pushing products. The number of online users is the new distribution system. Online is how people find out about new products and how they receive new products. And in this new distribution system, it is the large companies who have the advantage because they already have the users, such as Microsoft through your Windows subscription, Apple through your Apple account, Google through your YouTube login and Google email, Meta through your Instagram account.

In this new distribution system, small companies no longer have the advantage they once did against large companies. Back in the 70s, 80s, and 90s, the small companies would have the advantage of growing geographically because large companies generally did not think it worthwhile to chase down customers in the underserved parts of the United States. The giant Sears Roebuck was not inclined to chase customers in the small towns in Arkansas and Missouri. The pursuit of this advantage was left to the likes of Sam Walton, who knew the needs of underserved people in these places better than the people in Sears’s corporate headquarters and could pursue this potential customer in a cost-effective way. And so, growing from a smaller base Wal-Mart as a smaller company had much better growth prospects.

But in the online world, small companies with new products no longer have the advantage that they once did because no potential new customer is overlooked because of cost. In an online world the cost to reach a customer is marketing, specifically online marketing, not the cost to build a physical location. And the large company is, in this sense, indifferent to where the customer is located.  It is no coincidence that the largest companies in the world are the ones that have the largest user bases—Amazon, Apple, Google, Meta, Netflix, and Microsoft chief among them.

To compete against this new distribution, the smaller company will have needed to reach the new user before the large company has reached them using the same amount of marketing dollars.  Also, they must get to the user before they present the new product or as they are presenting the new product, whereas the large company, often having already connected with the user, merely has to present their version of the product. And so, the small company must often grow against the online presence of a larger company.

Faced with these challenges, the only advantage left to a smaller company is to offer a product that a large company cannot offer or a better version of that product. To be sure, there will be new and young companies that develop products that will be hard to imitate, but many of the other advantages of being a smaller company have dissipated. This is an important issue to consider in an era in which AI companies are the smaller companies vying to make inroads on the distribution system established by the larger technology companies, Apple, Google, Meta, Microsoft, while they are all creating similar products.