Thursday, January 3, 2013

Equities: Not Enough To Go Around?

Pimco's Bill Gross has talked provocatively about the death of the "cult of equities." He sagely makes a case for the nominal,expected rate of return from a balanced portfolio being in the range of 3%.  Bond strategists would be hard pressed to argue that future nominal returns from bonds could come anywhere close to the returns from the past decade.  Stocks, in Bill Gross' view, could reasonably be expected to deliver about a 4% nominal return per annum in the future.

Now, for pension funds and individual investors to achieve adequate rates of return for their current or future retirement needs, the virtues of equities are universally trumpeted.  This is very reasonable. My question is: what will the future supply of investment grade equities look like, and will they match up with the traditional requirements of institutional investors?  I'm not sure that they will, which is a problem.

Traditional exchanges like NYSE Euronext are facing an uncertain future, especially from the profitability standpoint and more so from relevance.  Fewer and fewer companies have been floating equity and listing their shares on traditional exchanges.  The following statistics are from Bloomberg as reported by MarketWatch. In 2002, the London Stock Exchange had 1,531 listed companies.  At year-end 2012, only 936 were listed on LSE.

$112 billion in capital was raised through initial public offerings in 2012, the lowest level since 2008.  Asian IPOs were 50 percent of their 2011 level.  European issuance was one-third of the 2011 level.  U.S. new issue volume was relatively flat to 2011, but only because of the massive, but disappointing Facebook IPO.

One year does not a trend make.  Definitely something to always bear in mind.  These numbers are cyclical. Yes, but coming after an accelerating equity market towards the close of 2012, and reduced worries about the euro collapse, Grexit, and the U.S. fiscal cliff, one would expect bankers to be queuing up offerings for the first part of 2013.  That may be the case, but let's see.

Where are the new issues going to come from?  Probably from emerging markets, which are the future as the broker newsletters say.

The whole notion of public companies which are of interest to large, institutional investors is not something that is in the psychic wheelhouse of entrepreneurs in Asia, India, Brazil or Russia.  Investment-grade public companies need to report about their quarterly financial results, risk management, corporate governance, internal controls, political contributions, sustainability, climate change, conflict minerals, executive compensation, related party transactions and so on.  Very few of these processes, procedures and values are naturally occurring in the psyches of powerful entrepreneurial families or oligarchs.  In fact, why bother learning them?

Equity risk premia have been falling, as have price-earnings ratios for seasoned companies and valuations for initial public offerings. Given some of the well known scandals among larger capitalization companies, such as Satyam and Sino Forest, institutional investors' appetite for risk has been diminished.  The number of names in which mutual funds can take a 2-3% stake while still sleeping at night is diminishing, which means the portfolio of many emerging market funds are looking strikingly similar.

Meanwhile, on the established company front worldwide, the capitalization leaders will be generating much of their expected return from dividends, buybacks and capital structure management. Will today's mega-caps be replaced by social media companies?  The evidence today is not compelling to make the argument.

The cult of equity may very well be dying, as Bill Gross says.  If some of the older horses are putting themselves out to pasture, there may not be enough attractive young mustangs at the auction to attract middle aged portfolio managers who need reliable financials, dividends, predictability, liquidity, strong boards and managements that are stewards of shareholder resources.

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