More Reason To Like “Cottage Industrials”

Yesterday, I put forward the idea that the age of giant corporations was over. Instead, I wrote, bet on the small guy. The cottage industrial is what I called the smaller, more flexible, flatter, owner-managed enterprise, as compared with the giants of industry.

Companies can get too big. There is such a thing as diseconomies of scale, which occurs when companies get less efficient after reaching a certain size.

A reader sent me a fascinating note on this idea from a New York Times Magazine article by Jonah Lehrer about the work of Geoffrey West. (“A Physicist Solves the City.”) Let’s take a deeper look…

West is a theoretical physicist turning his talents to the study of cities and corporations. There are a number of affinities between the two. There is also a big difference: Cities hardly ever die, while corporation routinely do. “As West notes,” Lehrer writes, “Hurricane Katrina couldn’t wipe out New Orleans, and a nuclear bomb did not erase Hiroshima from the map. In contrast, where are Pan Am and Enron today? The modern corporation has an average life span of 40-50 years.”


An excerpt explains:

“After buying data on more than 23,000 publicly traded companies, Bettencourt and West discovered that corporate productivity, unlike urban productivity, was entirely sublinear. As the number of employees grows, the amount of profit per employee shrinks. West gets giddy when he shows me the linear regression charts. ‘Look at this bloody plot,’ he says. ‘It’s ridiculous how well the points line up.’ The graph reflects the bleak reality of corporate growth, in which efficiencies of scale are almost always outweighed by the burdens of bureaucracy. ‘When a company starts out, it’s all about the new idea,’ West says. ‘And then, if the company gets lucky, the idea takes off. Everybody is happy and rich. But then management starts worrying about the bottom line, and so all these people are hired to keep track of the paper clips. This is the beginning of the end.’

“The danger, West says, is that the inevitable decline in profit per employee makes large companies increasingly vulnerable to market volatility. Since the company now has to support an expensive staff — overhead costs increase with size — even a minor disturbance can lead to significant losses. As West puts it, ‘Companies are killed by their need to keep on getting bigger.’”

In a free market, such larger companies would run into all kinds of problems. Losses and lost market share would force them to shrink, or they would go out of business.

But we don’t live in a free market.

Instead, companies grow unnaturally large in a web of state privilege. It is easy to see this with banks. Is there any doubt that the too-big-too-fail banks would not be as big as they are without aid from the government? The banking industry is a cartel, underwritten by the Federal Reserve and the taxpayer. Without that super-structure, I think banks would be much smaller.

This phenomenon goes way beyond just banks. It covers nearly everything.

  •  The giant military-industrial complex is impossible to imagine without government aid.
  •  The sprawling retail businesses would be impossible if the taxpayer did not underwrite the massive costs to build roads, bridges and ports.
  •  Huge pharmaceutical companies and tech giants like Intel or Microsoft are impossible without the state enforcing patents.

The fact is the state, through its policies, forces centralization and bigness. It’s even deeper than that and affects the social networks that evolve in a society (state-run schools, prisons, etc.).

This is an old story (19th-century American libertarians picked up on it, especially after the Civil War. Railroad land grants were an obvious government handout to big business, for instance). But even so, it is largely unappreciated, even by people who call themselves “libertarian.” These are people whose knee-jerk reaction is to defend the Keystone Pipeline project, even though it tramples all over the rights of farmers and ranchers through the use of eminent domain. Or people who jump to defend Wal-Mart’s laying waste to small American retailers on the grounds that it “better met the needs of its customers,” despite the fact that Wal-Mart has benefited tremendously from state privilege and subsidies. It’s no more a free-market institution than Fannie Mae.

Anyway, I digress. Even if the free-market angle were not true, West’s points still stand. And they back a lot of older research about corporate bureaucracy. I recall a witty line from economist Kenneth Boulding. I don’t know where I read it originally, but I found it on the Web:

“[T]he larger and more authoritarian the organization, the better the chance that its top decision-makers will be operating in purely imaginary worlds. This perhaps is the most fundamental reason for supposing that there are ultimately diminishing returns to scale.”

This makes intuitive sense. The guys at the top of a hierarchy of any kind are likely to have a very different view than the guys at the bottom doing the work. This is another point in favor of those flatter cottage industrials.

The reader who pointed me to the New York Times Magazine piece also wrote:

“I’m sure you are familiar with Clayton Christensen’s Innovator’s Dilemma. It doesn’t talk specifically about richer returns, but about how companies can get so large that they have to pursue profitable ventures that can pay for their cost structure: They cannot afford to pursue new opportunities that are less lucrative, at present. If you’ve not read the book, it is superb; even my artsy, Occupy-obsessed, left-wing students loved it.”

This idea directly applies to our cottage industrial theme. It shows again the advantage of low-cost, entrepreneurial firms against the mastodons of the field.

To sum up on this theme: Stick with the smaller, entrepreneurial companies (btw, these are the ones I recommend to my readers.) They have a better shot at finding the seams of growth and opportunity in what is a stagnant and trouble-filled economic landscape. Ironically, as West points out, these firms are also better able to weather the inevitable storms.

The age of the giant corporation as a great investment is over. The age of the cottage industrials has arrived.

Chris Mayer

Original article posted on Daily Resource Hunter

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Chris Mayer

Chris Mayer learned the art of valuing companies the hard way — clocking a decade as a corporate banker while also earning his MBA. He never lost money on a single deal. In 2004, he founded Capital & Crisis, making his one-of-a-kind research available to the general public. His second letter, Mayer’s Special...

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