Image Credit: Christophe Vorlet
By Jason Zweig | June 30, 2017 12:36 pm ET
How much should you care about the decline in the number of publicly traded companies?
The number of stocks has halved over the past two decades, to less than 3,600 from nearly 7,400, with most of the declines coming among the smallest companies.
That, I argued in a column last weekend, may be making it tougher for stock pickers to beat the market and for investors to forecast future returns from past data. Now I’m not so sure. In the past few days, I’ve heard from several leading investors and researchers who feel I got parts of that story wrong. There’s a lot that I — and you — can learn from their criticisms, mainly about the role that small companies play in the markets.
Ronen Israel, a partner at AQR Capital Management, a firm in Greenwich, Conn., that manages more than $180 billion in assets, doesn’t think the decline in small companies is a big deal.
“That part of the universe is so small,” says Mr. Israel, “that it doesn’t really affect most portfolio managers because they can’t invest there anyway.”
The biggest disappearance has occurred among the very smallest companies in the market. But the 1,900 most minuscule companies combined are only 2% of the total value of the U.S. stock market, according to the Center for Research in Security Prices at the University of Chicago’s Booth School of Business.
Many such minnows have market values barely above $15 million, making them untouchable for the typical fund manager — and unlikely to be a major factor in the performance of stock pickers, says Mr. Israel.
What about so-called factor investing, which selects groups of stocks based on how big companies are, how much their shares fluctuate, how expensive their shares are relative to asset value and so on? Much of that underlying research is based on periods when twice as many stocks existed as today. Is it still valid?
So many of the stocks that disappeared were so small that they shouldn’t overly influence the results, says Mr. Israel, except in strategies that weight stocks equally rather than by size as most indexes do.
Larry Swedroe, director of research at Buckingham Asset Management in St. Louis, points out that the performance of small stocks has been relatively consistent all the way back to 1926, regardless of how many there were.
Jay Ritter, a finance professor at the University of Florida who is a leading authority on initial public offerings, says the shrinkage of small stocks isn’t new. While it was common for more small companies (with under $50 million in sales) than big ones to sell shares to the public in the 1980s and 1990s, that hasn’t happened in a single year since 2000.
The new chairman of the Securities and Exchange Commission, Jay Clayton, has said that he hopes to encourage more small companies to list their shares, at least partly by reducing red tape.
Regulatory costs aren’t the main issue, says Prof. Ritter: “Small companies are having a lot of difficulties competing with big companies, mainly due to technology and globalization.”
For evidence, look no further than the IPO of the meal-kit delivery service Blue Apron Holdings on June 29. It arrived on the table cold, closing unchanged at $10 on its first day, after the company had sought to get between $15 and $17. The offering faltered partly because of the threat of intense competition from Amazon.com.
“Getting big fast is more important than it used to be,” says Prof. Ritter. So the venture-capital funds backing many startups protect their investments by merging with or selling to other companies rather than taking them public.
In the 1990s, IPOs regularly accounted for more than half of all “exits,” or sales, by venture-capital firms; from 2001 onward, they haven’t accounted for more than 20% in a single year, calculates Prof. Ritter.
The losers here are small investors who can’t invest in VC firms, says Brian Buenneke, a partner at Pantheon Ventures in San Francisco, which manages about $36 billion in venture-capital and private-equity funds. “Individual investors have access to fewer companies and slower growth. They’re really getting shut out.”
The earliest and biggest gains are increasingly being captured by a wealthy, closed and connected investing clique. If that continues, it could even jeopardize popular support for free-market policies.
It’s worth pointing out that most small companies, even the most promising ones, end up underperforming. And big investors have poured so much money into venture-capital and private-equity funds that recent returns, on average, haven’t been significantly different than in the public markets. But those few who win big win very big indeed.
“Historically, great companies went public far earlier and in theory anyone could identify their promise and be rewarded for taking that risk,” says Lauren Loktev, a partner at Collaborative Fund, a New York-based firm that has invested about $125 million in startup companies. “Now, by the time they go public, the exponential growth isn’t there anymore.”
Source: The Wall Street Journal, http://on.wsj.com/2t9eC4x
For further reading:
Definitions of HERDING, IPO, and SMART BETA in The Devil’s Financial Dictionary
Michael J. Mauboussin et al., “The Incredible Shrinking Universe of Stocks”
Data on IPOs from Jay Ritter, University of Florida
Kathleen Kahle and Rene Stulz, “Is the American Public Corporation in Trouble?”
Craig Doidge et al., “The U.S. Listing Gap”
Gregory W. Brown et al., “What Do Different Commercial Data Sets Tell Us About Private Equity Performance?” (see, especially, Table 8)
Pantheon Ventures, “The Shrinking Public Equity Market and Why It Matters”
Morgan Housel, “The Bad Side of a Good Idea”
Alexander Ljungqvist et al., “Private Equity’s Unintended Dark Side: On the Economic Consequences of Excessive Delistings”