Articles

The Winner's Curse
By Rob Arnott, Lillian Wu

Page 2 of 16

Recent research confirms that larger companies typically exhibit a lower growth rate and earn a lower return on capital (e.g., Milano 2011) than smaller companies. Therefore, in practice, what economists refer to as "dis-economies of scale" can be a dominating effect as large companies grow: As a behemoth company grows to dominate its sector in terms of production efficiency and scale, its rosy performance may become a thing of the past.

Being large puts the company under the scrutinizing lights of regulators. Arnott (2005, 2010) points out a potential connection between sector leaders’ misfortunes and the increase in government regulation. In a world of intense regulation, the relentless success of the top companies makes them ever bigger targets for regulatory scrutiny.

Was Goldman Sachs targeted with civil and criminal fraud charges in 2009-2010 because it has criminal intent to defraud its clients, while its competition is pure as the driven snow? Or has Goldman become a symbol of success-to-excess, to an extent that prompts populists and pundits to want it to suffer?

Is Exxon Mobil regularly pilloried in Washington because its business practices are monopolistic, its profit margins obscene and its product viewed as polluting and distasteful (never mind that we all buy it)? Or is it because the company’s relentless business success makes it a popular target?

Of course, none of this is new.

Initially, Bank of America management thought it would be lauded by the political elite for buying (and saving!) Merrill Lynch when Lehman imploded. Instead, it found itself on the proverbial horns of a dilemma when Merrill disclosed an extra $20 billion of losses before the deal closed. Bank of America could have canceled the deal by invoking the material adverse conditions (MAC) clause, or it could have proceeded and sought additional sources of capital. Threats were reportedly made, and Bank of America ultimately chose to proceed. Instead of being lauded for stepping up, it was pilloried for needing an infusion of capital, which it repaid, the CEO was driven out and the company was then sued for not canceling the deal.

How much of this controversy was linked to the specific events surrounding the acquisition of Merrill, and how much was because Bank of America, by most measures, was the largest bank in the United States? How many of Citi’s "moments in the spotlight" have been due to the fact that it was Bank of America’s predecessor in the No. 1 spot?

We’ll never know the answers to these questions, but the pattern is familiar. Microsoft’s opportunity in the spotlight came a decade ago, when it was attacked on the grounds of "monopolistic" business practices, in a repeat of similar earlier battles for IBM in the prior decade. In the 1980s, AT&T was successfully dismantled on the same basis. This script is now being revived for Google, No. 1 among search engines.

Throughout this article, we’re focusing on market capitalization as our measure of company size.¹ The very business practices that propel an organization to No. 1 in market cap—aggressiveness, focus, canny outmaneuvering of the competition—become unacceptable if you’re wearing the yellow jersey.² Being No. 1 means always having to say you’re sorry!

Being large also pushes the company into the headlines, "rewarding" the company with the highest coverage rate in mainstream media. Fang and Peress (2009) find that the coverage rate for NYSE stocks (mainly large stocks) is three to four times larger than for Nasdaq stocks. Too much media exposure is not always a blessing: That same study concludes that stocks with no media coverage earn higher returns than those with high media coverage.