The Key of Investing: Understanding the Competitive Dynamics
How you should approach investing to get to the next level
Hi everyone!
Today, I have seen this tweet from Long Equity, where he explained why most of his portfolio is in larger companies.
This is a very interesting topic, and mostly for spanish investors, because we are very use to see deep value investors that are really focused on small caps.
I mostly agree with Long Equity. Nevertheless, the first and the third points are not really important into this discussion for me.
The Case for Investing in Larger Companies: A Comprehensive Analysis
Investing in large companies has been a cornerstone of successful portfolios for decades. However, in Spain and many other markets, there is a tendency among some investors to focus on small-cap stocks, driven by the belief that they offer higher growth potential. While smaller companies can indeed outperform, this article argues that larger companies—especially those dominating their industries—deserve more attention. Below, I will dive deep into the reasons behind this, explore the role of competitive dynamics, and analyze industries that present unique investment opportunities.
Why Large Companies Often Outperform Smaller Ones: A Historical Perspective
In 2011, Apple became the largest company in the world by market capitalization, and its stock price has since risen by over 1,500%. This achievement has often led to the assumption that large companies, once they reach the top, are likely to continue delivering exceptional returns. However, it is essential to question whether such growth can continue indefinitely.
Historical Performance of Large Companies
Looking at the historical performance of large-cap companies, the situation is more nuanced. A study by J.P. Morgan published in the "Guide to the Markets" found that the largest companies by market capitalization do not necessarily continue to outperform after reaching the top. For instance, from 1980 to 2016, the top 10 companies by market cap underperformed the broader market by 1.5% annually on average. This suggests that, while large companies may have experienced explosive growth at one point, maintaining dominance often becomes harder due to competitive pressures and market saturation.
However, this doesn't mean large companies are poor investments. Instead, we need to examine what drives their performance.
The Pareto Principle and Stock Market Returns
A key factor in understanding the performance of large companies is the Pareto Principle—the idea that 80% of the effects come from 20% of the causes. In stock markets, this principle is often reflected in the fact that a small number of companies generate most of the market’s returns. According to a Harvard Business Review article, 95% of all stock market returns over the past century have come from just 5% of the companies. This phenomenon is not a coincidence. Large companies that dominate their sectors are more likely to benefit from network effects, economies of scale, and the ability to command premium prices due to their market power.
For example, companies like Apple, Microsoft, and Amazon dominate their respective industries and have delivered consistent returns to shareholders. While it is true that their growth rates may slow as they mature, these companies are often still able to achieve returns that outperform the broader market, thanks to their competitive advantages and ability to innovate.
Competitive Dynamics and Market Structures: A Shift in Understanding
A common argument against investing in large companies is the belief that smaller companies offer higher growth potential due to their flexibility and ability to disrupt established players. While this may be true in some cases, the economic theories of monopolistic competition and dynamic efficiency offer a more nuanced understanding of how competitive dynamics work.
Monopolistic Competition vs. Perfect Competition
Traditional economic models often suggest that markets operate under perfect competition, where numerous companies compete on equal footing, and no one company can significantly influence the market. However, in reality, most industries operate under monopolistic competition. This market structure allows companies to differentiate their products and services while still facing competition. Companies that are able to effectively differentiate themselves from competitors can achieve high margins and sustainable profits.
The Theory of Dynamic Efficiency
As Jesús Huerta de Soto notes in his work, The Theory of Dynamic Efficiency, traditional economic models that focus on static competition fail to capture the complexities of real-world markets. Dynamic efficiency—defined as the ability of firms to adapt, innovate, and evolve in response to changing market conditions—better explains why some companies outperform others over the long term. For example, Amazon didn't just disrupt retail; it completely transformed logistics, cloud computing, and even artificial intelligence, enabling it to build a diversified revenue base and sustainable competitive advantages.
The Role of Industry Dominance: Why Large Companies Win
It’s not just about company size—it’s about how well a company competes within its industry. For investors, understanding the competitive dynamics of an industry is crucial to determining which companies are most likely to succeed over the long term. In industries where network effects or barriers to entry exist, large companies tend to have a significant advantage.
Key Factors to Consider in Industry Dynamics
To assess the potential of a company, investors should focus on several key factors:
Key Purchase Criteria: What do customers look for in this industry? For example, in digital payments, speed, security, and ease of use are critical.
Value Proposition: What does the company offer that others do not? For instance, Apple’s ecosystem offers unmatched integration across devices, creating a lock-in effect for customers.
Supply Chain Dynamics: How strong is the company’s position in its supply chain? Companies with dominant supply chains can control costs, improve margins, and mitigate risks. Taiwan Semiconductors, for example, has a commanding position in semiconductor manufacturing, giving it an edge over competitors.
By understanding these factors, investors can identify companies with strong long-term growth potential, regardless of their size.
Focusing on High-Potential Industries: A Case Study of Key Sectors
While the debate about large vs. small companies is important, it's also critical to look at the industries that present the most promising investment opportunities. Below are four sectors where competitive dynamics favor a smaller number of dominant players:
Digital Payments: Companies like Visa, or Mastercard dominate the global digital payments market. According to a McKinsey report, global digital payments are expected to grow by 12% annually through 2026, with a significant portion of this growth concentrated among these few players.
Cloud Computing: The cloud industry is another example where large companies have a distinct advantage. Amazon Web Services (AWS) and Microsoft Azure together control more than 50% of the global cloud market. According to Gartner, AWS had a 32% market share in 2023, followed by Azure with 20%, leaving smaller players with little room to challenge these giants.
Digital Advertising: Google and Facebook (now Meta) control the majority of the digital advertising market. In 2023, Google captured 28.9% of global digital ad revenue, while Meta took 25.2%, according to eMarketer. These companies benefit from vast user data and sophisticated algorithms that smaller companies cannot replicate.
Semiconductors: The semiconductor industry is essential to modern technology. Companies like NVIDIA, and TSMC dominate this sector. According to a Statista report, TSMC controlled 54.7% of the global semiconductor foundry market in 2023, reinforcing its position as a critical player.
Conclusion: A Balanced Approach to Investing
The question of whether to invest in larger or smaller companies is not a binary choice. Instead, it is about understanding the competitive dynamics of each industry and the relative strength of individual companies within those industries. While large companies may seem less attractive due to slower growth rates, they offer stability, resilience, and, in many cases, the ability to dominate their respective markets.
For investors, it’s essential to look beyond company size and focus on how well a company competes. By understanding key purchase criteria, value propositions, and supply chain dynamics, investors can identify winners in both large and small-cap stocks. At the same time, staying informed about industry trends—such as those in digital payments, cloud computing, digital advertising, and semiconductors—will enable investors to make more informed decisions and achieve superior returns.
As the Spanish investment community continues to grow, it is essential to foster deeper discussions around these industries, competitive strategies, and long-term investment approaches. This is why I am organizing an exclusive event on December 19th, where Álvaro Domínguez, an expert in the Healthcare industry, will share insights on investing in this rapidly evolving sector. If you are interested in joining our community and learning more, please feel free to reach out.
Pedro Gutiérrez,
Founder & Analyst, Gutiérrez Capital