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Why Bigger Isn't Better for Investors

The failed BAE-EADS merger proposal got me thinking about corporate value. What is value exactly? The advocates of that particular planned tie-up spoke glowingly about the size and implied strength of the new entity, principally about how it could "take on" U.S. defense giants such as Boeing .

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This may or not be true, but is it something the shareholders would have actually benefited from in the long run? Is size in itself a competitive advantage? Would it really have been positive for value creation?

Maybe orthodox principles can guide our thoughts on this. In the economists' world of perfect rational investors, in theory shareholders do not need the agents who run the corporate entity on their behalf to "diversify", because shareholders can do that for themselves.

By that thinking, if I am running an organization based in the EU, I shouldn't use diversification as an argument to acquire a business in an emerging economy. Of course, acquisitions often occur because the buying company thinks it can do a better job of the target firm than the existing managers. Sometimes that is true, and sometimes it is not.

But what about when a firm divests businesses? Conglomerates used to be the rage in the Western economy, and are still a major factor in the Asia-Pacific region, with examples of parent organizations that run everything from engineering firms to banks. It is tempting to think that if such firms hived-off off those parts that weren't "core" to the business, shareholders would benefit. Certainly that has been the case in the West on many occasions.

What is the primary objective set for a company's managers? To maximize shareholder return. Today's companies have many other objectives of course, including addressing the interests of other stakeholders and the wider community within which they operate, and rightly so. But the shareholder return objective must remain paramount, otherwise shareholders would be better off investing elsewhere. But by return we do mean genuine value creation, not (for example) short-term gains that may be illusory.

The challenge for corporates in the post-crash environment is to remain competitive. That calls for stronger engagement with customers, and sticking to one's areas of genuine expertise. And here the size argument falls down a bit. One can't be an expert at everything. If we are focusing on shareholder value, then the future may be the niche company, the focused operator that sticks to what it knows it has expertise in, and treats every customer as if he is their only customer.

And this is the crux of it. A retrenchment may benefit large company competitive advantage as well. The paradox would be growing smaller to remain competitive, as opposed to merging with or acquiring firms in a constant desire for "growth" and the belief that bigger is better. The part of the financial statement that necessarily needs to get larger is "return on capital", as opposed to "assets".

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