The Small Firm Effect
This is an interesting anomaly that has bugged Wall Street for decades. Initially, the finding of this anomaly came from a well-documented observation in financial research. In the US, small-cap stocks outperformed large-cap stocks by three percent per annum over the period 1927–2011. Global small-cap stocks also tend to outperform global large-cap stocks over long time horizons.
Well… I can throw more and more data about this anomaly research in the past. But what I want to show is the prospect of smaller firms in the stock market.
Leicester City Won the Premier League
On May 2, 2016, Leicester City Football Club won the English Premier League, not one of those other premier leagues. Leicester’s win also records the first time in the club’s history. The season also saw history be made for individual players within the team, as striker?Jamie Vardy?broke the record for consecutive games with a goal in the Premier League and winger?Riyad Mahrez?became the first African and first Algerian player to be the recipient of the?PFA Players’ Player of the Year.
I found an interesting analysis from an article from The Analyst, and I’ll quote some insights.
The Effectiveness of Player’s Draft
N’Golo Kanté is from Paris, Riyad Mahrez was born in a Paris suburb, Jamie Vardy is from the Paris of South Yorkshire (Sheffield), and no one cares where Steve Walsh is from. In Leicester’s Board, familiar names like Craig Shakespeare remained along with less familiar names like Steve Walsh. He was then a scout with a knack for identifying undervalued talent.
Walsh had already brought in Vardy and Mahrez. On Aug. 3, 2015, Kanté joined them. Beside Kante, there’s Danny Drinkwater who led the team in ball recoveries. The duo was second and third in that category that season behind Aston Villa’s Idrissa Gueye, and Arsenal were the only other team with two players in the top 15 (Aaron Ramsey and Nacho Monreal).
Then, a free transfer defender Christian Fuchs came in with his long throws has created lots of chances for the frontline. In the attacking stance, Kanté was the holding midfielder disrupting attacks, Mahrez was the lovely left foot stretched wide out right with 28 direct goal involvements, and Vardy? Jamie Vardy was fast.
Playstyle
Leicester had the fastest direct speed in the division (2.26 metres advanced toward goal per second), though that’s hardly ever indicative of success. The next three teams were West Brom, Sunderland and Norwich City. Those teams finished 14th or worse. Leicester’s average sequence time of 5.5 seconds was the lowest in the division. Their average sequence length of 11.5 metres progressed toward goal was the lowest in the division. Ranieri’s side led the division in ball recoveries, and their 10 direct attack goals were tied with Newcastle for the most in the division.
You can see, their playstyle is about letting the opposition come to them.
According to Huth:
“You’re at your worst when you’re chasing the game, you make stupid decisions. You don’t track your runner, you get too excited, you get out of position. … Some teams did exactly that. Twenty minutes into the game, they were one-nil down and they were doing stupid stuff, both full backs bombing on leaving one on one with Vardy on the halfway line. I’m like, ‘What do you think you are doing? You’re going to lose.’”
‘We just need to let them come on to us. Let them come on, soak up the pressure, soak up the pressure,”
“Then with one or two quick passes, we are 60, 70 yards up the pitch.”
The result is Leicester City topped the Premier League for 149 days in 2015–16.
Why Small Firm Might Follow the Same Principle
The reason why Leicester’s story interesting is because how uncommon it now is for a new club to win the topflight of English football. What you know: Leicester City won their first English top-flight title in 2015–16. What you perhaps don’t know: The previous team to win their first top-division title in England was Nottingham Forest in 1977–78.
What we can observe from Leicester is the combination of effectiveness in player’s core skill & positioning with their playstyle which created very effective and fast counterattack. This create an unique playstyle for Leicester under new players draft and new manager.
Now let’s get back to the topic.
I will use 2 companies from coal-producer industry as example for comparison: Bumi Resources (BUMI) and Indo Tambangraya Megah (ITMG).
Company Profile
BUMI
BUMI business activities focus on 3 (three) main business lines, namely coal and oil and gas, as well as non-coal/minerals. The Company is the largest owner of coal reserves and coal resources in Indonesia, with capacities of 2.5 billion MT and 9.8 billion MT respectively, bringing the total to 12.3 billion MT. This business segment is managed by: PT Kaltim Prima Coal (KPC), PT Arutmin Indonesia (Arutmin), and PT Pendopo Energi Batubara. KPC produces Prima (High Calories), Pinang (Medium Calories), Melawan (Sub-Bituminous) and KPC 4200 (Sub-Bituminous) coal. Arutmin produces bituminous, sub-bituminous and low sub-bituminous coals. Pendopo produces Lignite coal. For the Mineral segment, since 2010 the Company has integrated all non-coal mineral mining assets under PT Bumi Resources Minerals Tbk (BRMS). BRMS’s business activities are carried out by various operational units, namely Dairi Prima Mineral which produces zinc and lead, Citra Palu Minerals which produces gold, Gorontalo Minerals which produces gold and copper and Linge Mineral Resources which produces gold.
ITMG
The company is involved in integrated coal mining, processing, logistics and trading. The parent company is Banpu Public Company Limited which is engaged in the energy sector based in Thailand. The company’s mine sites are located around South, East and Central Kalimantan and produce high-calorie coal products (>5000 kcal and above) of the thermal coal type which are marketed to various countries in the Asia Pacific region. In 2021 the Company produced 18.2 million tons and managed to sell 20.1 million tons of coal. The company benefited from the increase in coal commodity prices caused by the energy crisis in Western countries and the Russia-Ukraine war factor, so there is a prospect that sales will begin to be distributed to the European region in the future. The company’s strategy focuses on productivity and cost efficiency, as well as digitizing business processes that are applied to the Company’s mines. In the future, the Company will also start mining low-calorie coal through PT. Graha Panca Karsa which aims to fulfill DMO requirements.
That’s the company story, then the comparison.
Here’s a size comparison of ITMG vs BUMI:
We see that BUMI has a total asset of around 64.3 trillion rupiah and ITMG has 41.6 trillion rupiah. But let’s adjust the real asset amount of both companies:
Why reduce by cash? I’d like to find the amount of fixed assets to run the business. With cash deducted from the equation, the rest of the assets are land for development, mining sites, inventories, and other fixed assets. We can see that BUMI’s fixed assets are larger than ITMG by 3.4 times.
Now look at their performance:
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Now things are getting interesting.
BUMI recorded revenue around 30.3 trillion rupiah while ITMG recorded 57.8 trillion rupiah. Let me breakdown the premises:
From here, we can get some insights:
Company Playstyle
Coal is affected by anomaly after the initial COVID waves in 2020, which the price surges from 2021 to early 2023. But how does the index affect the companies?
To understand the impact, let’s use a metric called Average Selling Price (ASP)which measures average selling price during a period. Here’s a table of ASP from 2019–2022.
Did you see the pattern?
ITMG enjoyed the price surging, but BUMI seems to not ‘fully enjoyed the experience’. How does BUMI differs from ITMG if the product specification is on same type?
The key is Contract.
In commodities, a buyer might purchase specific goods either through spot or contract/futures. Spot is the current cost of that commodity, for current purchase, payment, and delivery while Futures is applied to a transaction involving the commodity that will occur later — literally, in the future. A commodity futures buyer is locking in a price in advance, for an upcoming delivery.
Now look at this table:
Confused? Here is the explanation:
Conclusion
Difference in contract setting technique has already led huge difference in Revenue. Even though ITMG has smaller assets than BUMI, the management playstyle in determining contract has outplayed BUMI. The coal specifications from both companies are similar (5000–6000 kcal) but ASP shows huge gap.
This is one of thousand reasons why I’m not always rely on company’s size. It’s much more interesting if a smaller company somehow can beat bigger companies in performance. Usually if that kind of event happened, it simply because of outstanding Management’s decisions.
I’d like to give another example of this case, which happened in Film Industry.
Have you watch the Raid series?
The Raid is a 2011?Indonesian?action thriller film?written, directed and edited by?Gareth Evans. The film stars?Iko Uwais, who previously worked with Evans in another action film,?Merantau, released in 2009. In the film, an elite squad is tasked to infiltrate a high-rise building run by a ruthless drug lord in the slums of?Jakarta; among them is Rama (played by Uwais), a veteran member of the team.
After its world premiere at the?Toronto International Film Festival?(TIFF), The Raid received positive reviews from critics.
But what’s more outstanding, The Raid 1 only spent $1.1 million and The Raid 2 spent $4.5 million USD.
Let’s compare Taken 3 and The Raid Series
Here’s a scene from Taken 3:?https://youtu.be/BsKfIrXMDtQ
And here’s scene from The Raid:?https://youtu.be/uMje7SrCtPI
Imagine Taken 3's budget is 48 million USD but has lower quality fighting scene compared to the Raid (not trying to discredit Taken 3, it has good story, but the fighting scene is just a no).
This is why efficiency in companies does matter. A good and wise efficiency can even lead to potential moat, which may be a future company’s added value and benefited shareholders.
Do not be trapped by “our asset is growing rapidly” but turns out to be zero-efficient.