Mega caps stocks, companies valued at more than $100bn, generally have needed something special in order to become so gigantic. However, not all mega-cap companies make good long-term investments. Therefore, determining whether or not this special something can endure is the key to successful investing over the long term. 
Below, we outline four of the key characteristics in favour of investing in mega-caps.
1) Diversification is key
Gigantic companies are generally much more diversified than smaller companies. Their businesses typically span geographic regions and offer multiple products. At some stage, all businesses experience some disruption. Being well-diversified means difficulties in a particular area do not cause critical damage. For instance, British-Dutch consumer goods company Unilever is diversified by geography – operating in 190 countries – and operationally – with thirteen core business sectors. This diversification makes the profits from mega-cap companies more predictable, where modern finance theory encourages big institutional investors to value such certainty.
2) Economies of scale
Mega-cap companies typically have substantial economies of scale. This means, from a financing perspective, rating agencies typically provide higher ratings for mega-caps, enabling the companies to borrow for less. Size also confers operational advantages. For instance, American payment network operator Visa is double the size of its closest competitor. This allows some mega-cap companies to provide lower-cost solutions.
3) Quality pools of talent
Mega-cap companies have the ability to attract and retain talent from smaller organisations, or to simply acquire high calibre employees. For example, the American parent company of Google, Alphabet, is expected to complete the acquisition of Fitbit by the end of the year. In one stroke, the company not only adds 28 million active users and more than 5 per cent of the global smartwatch market, but also a proven team.
4) Liquidity offers protection
Shares in mega-caps are typically highly liquid. People and institutions regularly trade in these stocks. This results in lower transaction costs, as the spread between the bid and ask price is low, allowing positions to be bought or sold more easily than for smaller companies. In risk-off environments, the relatively lower liquidity in smaller capitalisation stocks can mean share prices fall more dramatically than they do for larger companies, where there are more natural buyers of shares.
As mentioned earlier, not all mega-cap companies make good long-term investments. We separate them into charging elephants and sluggish dinosaurs. Charging elephants have found business niches which have facilitated growth. Typically, these firms have either generated some form of intellectual property, a product or technology, or have a brand synonymous with quality. The research and development and marketing budgets of the charging elephants makes competing with them a substantial challenge.
Charging elephants
For example, bringing a new single pharmaceutical product through all three phases of clinical trials typically costs upwards of $1bn, with considerable risk of failure along the way. British-Swedish pharmaceutical company AstraZeneca has nine such new products in its late-stage pipeline. However, most exciting for AstraZeneca investors is the huge number of pipeline projects using medicines already approved for different purposes and in different combinations. These typically have higher clinical trial success rates than new pharmaceutical products.
Another charging elephant is American technology giant Microsoft. Over the last twelve months, Microsoft spent almost $17.5bn on research and development. To put this into context, there are only about 20 listed software firms in the world with enterprise values of more than this amount. Put another way, this level of spending is more than half of the world’s other listed software companies. Microsoft’s products are ubiquitous and challenging the firm’s dominance in any of a number of fields would require very deep pockets.
Sluggish dinosaurs
Sluggish dinosaurs include companies beginning as state-backed entities, as well as groups operating in industries facing major structural headwinds – either environmental or other social factors. Culture is exceedingly important for how organisations run and can be challenging to change, and state-backed entities are typically inefficient and lack entrepreneurial management. This generally makes returns on capital low and growth unattractive.
Being big brings benefits, but bigger is not always better. Homing in on specific characteristics of quality mega-caps should allow investors to sleep easy, while the companies they own charge on.
James Cooke is manager of the Ashburton Global Leaders Equity fund. The views expressed above are his own and should not be taken as investment advice.