Big vs. Small: How Business Size Shapes Survival & Success

During their recent episode, Taylor, Carlisle, and Michael Gayed discussed Big vs. Small: How Business Size Shapes Survival & Success. Here’s an excerpt from the episode:

Tobias: Michael, we’re at the top of the hour. We usually do this– Jake has some veggies that he’s got a little learnings make benefit great, glorious nation of Value: After Hours. So, he’s going to share some of those with us and then we’ll come back on tariffs, credit spreads and a few other things.

Jake: Yeah. We’ve done a really good job of preparing for this too with the conversation, even though it was absolutely zero planning involved. [laughs] But this segment is called the physics of scale. Size isn’t just physics alone. It shapes also survival in biology, industry, business. Whether you’re a mouse or a multinational corporation or a startup, your chances of thriving depend on how well you manage these physics of scale.

And so, Isaac Newton, who, of course, was the mind behind unraveling gravity calculus, he also observed a simple but powerful truth. Small objects lose heat faster than large ones of the same shape. So, heat escapes through the surface area, but the energy stored depends on volume. So, the smaller something is, the higher its surface area to volume ratio is, so it cools more quickly. So, think about a cup of coffee, which can cool relatively fast versus a giant pot of soup, which stays warmer for much longer. It has to do with the surface area.

So, this applies both also to biology and evolution. So, take a mouse versus an elephant. Mice lose heat quickly and they need constant food, while elephants, because of their bulk, retain heat and they need to eat much less often. Arctic animals follow something called Bergman’s rule, which is these– They tend to be bigger bodies to conserve heat, which is why polar bears are larger than the relatives in warmer climates.

And then, there’s this thing called the island rule, which is, on islands, small animals will often evolve to become larger due to reduced predation, while larger animals will become smaller to adapt to limited resources. So, this is why we find fossilized dwarf elephants and why island rats tend to be much bigger than their mainland relatives. When you think about this changing environment, like when an asteroid hit and probably wiped out the dinosaurs, small mammals thrived. They had lower energy needs, faster reproduction cycles, burrowing behavior. Even though dinosaurs were dominant for 150 million years, they couldn’t adapt fast enough to these rapid climate changes.

So, these same physics, also of scale, apply in the industrial revolution. Thomas Newcomen built the first large, efficient steam engine. It actually wasn’t very efficient. But James Watt then came along and he added a separate condenser. And that dramatically improved the efficiency. What that allowed it to do was to make a much larger engine. Therefore, the loss of energy in it, the efficiency, there’s less loss because it was bigger because at greater volume to surface area, just like we were saying.

And then, as a fun side note. Watt wasn’t just an inventor, he’s also a businessman. And instead of selling the engines, he and his partner, Matthew Boulton, they license them, and taking a cut of the savings on coal. So, this was like an early subscription model with recurring revenue. Unless you think that SaaS businesses discovered some new holy grail.

Tobias: Coal as a service.

Jake: Coal? Yeah, coal savings– [crosstalk].

Tobias: Energy as a service. Power as a service.

Jake: Yeah. And so, these same physics also apply to business as well. Large corporations often dominate in stable periods, but can struggle with rapid changes. Of course, canonical examples of Kodak with digital photography. Blockbuster with streaming and Netflix. And small firms, just like small animals or a small cup of coffee, they burn resources more quickly because maybe they lack the purchasing power, supply chain efficiencies. And large firms are able to spread costs more efficiently, lowering their per unit expense.

So, think of a neighborhood bakery buys flour at retail, while a multinational buys in huge bulk quantities and then significantly cutting their cost per loaf. It’s a cliche at this point, but startups innovate quickly but often fail, while large corporations survive downturns but struggle to pivot and can miss technological turns.

So, I think it’s a little bit of a rule I would say that in stable environments, big corporations dominate. But in shifting environments, the small disruptors can thrive in niches. So, all of which has me wondering, as we’ve been talking about, why large caps have dominated over small caps over the last 15 years. Well, I would posit that perhaps, it was a bit like the dinosaurs benefiting from a period of relative calm.

Economic growth over that time was relatively steady, if not unspectacular. We were sub 3 GDP but pretty consistent. Wouldn’t that probably favor established players? Minimal global conflicts meant fewer disruptions. Of course, big tech does exhibit those network effects that we’ve talked about and seems to create natural monopolies. But I would also say then that regulatory wise, government has gotten much bigger, large firms with a lot of resources are able to navigate these complex compliance requirements and a small firm can’t afford to have a huge regulatory and lobbying team. And so, you’re going to naturally favor the incumbents then the bigger the government.

You might even be able to argue far enough that there was regulatory capture and allowed a lot of big companies to influence policies, further entrenching their dominance. As a result, small caps, like small mammals in the age of dinosaurs, struggled. So, now, we get to get a little bit more prognosticating. But what would we have to believe would happen to change this, and why would small caps potentially outperform over the set of track? I think it’d be interesting to see– Maybe today we’re at a bit of a turning point.

AI disruption might level the playing field. This DeepSeek thing that came out maybe is a little bit of a glimpse of that. Maybe you don’t actually have to be a huge company to make some novel breakthroughs. Geopolitical instability, Ukraine, Middle east. Of course, maybe that’s shifts a little bit more to the benefit of agile players and not the big guys. Government deregulation might allow smaller firms to find their footing. We’ll see how much change actually sticks from Elon’s Doge after all the dust from the legal battles clears. I feel like that’s potentially pushing in the opposite direction of what we’ve seen the 15 years before.

And then, economic cycles probably favor small caps in expansionary periods as they tend to see their revenue grow faster. Maybe we are entering into some type of a golden age. I don’t know, some people are arguing that. And then, of course, you just have the valuation gap, like small caps currently trading at a significant discount compared to their large caps, which all else equal, you would want to bet on something that was cheaper than more expensive.

But anyway, the final takeaway. I think there’s no universal advantage to being big or small. It really depends on what’s being called for by the environment.

Tobias: Good one, JT. I don’t know if it’s Hussman or somebody else has talked about. There’s an accounting identity, where the spending of government shows up as the profit of-

Jake: [unintelligible 00:38:37]

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