Seth Klarman: The Size Disadvantage For Large Institutional Investors

In his book – Margin of Safety, Seth Klarman explains why major money management firms focus on large-capitalization securities, as analyzing smaller companies isn’t justifiable due to the modest investment amounts involved.

For instance, a manager of a $1 billion portfolio may invest $50 million in each of twenty stocks, avoiding illiquid positions by limiting investments to 5% of a company’s shares. This necessitates investing in companies with a minimum $1 billion market capitalization, which reduce the investment pool. This self-imposed constraint, driven by portfolio size, excludes thousands of smaller companies from consideration, regardless of their individual merit.

Here’s an excerpt from the book:

Most of the major money management firms consider only large-capitalization securities for investment. These institutions cannot justify analyzing small and medium-sized companies in which only modest amounts could ever be invested.

To illustrate this point, consider a manager at a very large institution who oversees a $1 billion portfolio. To achieve reasonable but not excessive diversification, the manager may have a policy of investing $50 million in each of twenty different stocks.

To avoid owning illiquid positions, investments might be limited to no more than 5 percent of the outstanding shares of any one company. In combination these rules imply owning shares of companies with a minimum market capitalization of $1 billion each (5 percent of $1 billion is $50 million).

At the beginning of 1991 there were only 559 companies with market capitalizations this large, a fairly small universe. I refer to this type of limitation on institutional investors’ behavior as a self-imposed constraint.

This one is not, however, a completely arbitrary rule adopted by managers; the size of the portfolio dictates such a restriction. Unfortunately for the clients of large money managers, like the one in this example, thousands of companies are automatically excluded from investment consideration regardless of individual merit.

You can find a copy of the book here:

Margin of Safety – Seth Klarman