Friday, September 4, 2015

A Shrinking U.S. Equity Market?

$173 trillion in investable assets in all forms of retirement funds.  Thousands of mutual funds in the U.S., more worldwide, looking for equity investments, as advisers continue to trumpet the need to own high equity allocations in order to participate in global economic growth, particularly outside of the developed markets.

Of course, developed economies, particularly the U.S., will continue to grow too, despite current doom and gloom.

Right now, governance lawyers trumpet the need for shareholder activism by all institutional investors.

Investors want mature companies to retire their outstanding share bases in order to artificially pump up share prices, never mind the longer term growth prospects for the ongoing company.

Private equity sponsors are awash in dollars, and everyone is seeking higher returns after years of central bank-enabled lower rates around the world.  They look to take out mature firms which they judge to be under performing.

What happens when you look into the stew pot after throwing in all these ingredients?  It may be "Honey, I Shrunk The Investable Equity Market!"  There may not be enough listed, liquid, institutional quality U.S. equities to satisfy the appetites for them!

It's something we've long suspected could happen, and now a National Bureau of Economic Research Working Paper 21181 (May 2015) by Dodge, Karolyi, and Stulz says that we may arrived in such an undesirable situation already.  A copy of the paper just landed on my desk, but interested readers with AEA or other professional memberships can access a copy through NBER.

The abstract has the punchline, and since this is publicly available, I reproduce it:
"The U.S. had 14% fewer exchange-listed firms in 2012 than in 1975. Relative to other countries, the U.S. now has abnormally few listed firms given its level of development and the quality of its institutions. We call this the “U.S. listing gap” and investigate possible explanations for it. We rule out industry changes, changes in listing requirements, and the reforms of the early 2000s as explanations for the gap. We show that the probability that a firm is listed has fallen since the listing peak in 1996 for all firm size categories though more so for smaller firms. From 1997 to the end of our sample period in 2012, the new list rate is low and the delist rate is high compared to U.S. history and to other countries. High delists account for roughly 46% of the listing gap and low new lists for 54%. The high delist rate is explained by an unusually high rate of acquisitions of publicly-listed firms compared to previous U.S. history and to other countries."
If their analysis is correct, the real situation may be worse than it seems. Delists account for 46% of the listing gap, according to the authors. But, the delisting gap should be higher than it is.  There are so many microcap companies that trade below $5, and more below $10 a share that really have no business continuing to be public.  I've long felt that boards should work to perhaps consolidate some of these companies, to create a portfolio of products and revenue that might be attractive to institutional investors.  Institutionally, this isn't possible because companies don't want to throw in the towel and merge with another weak sister.  Most large mutual funds are not permitted to invest in companies like these anyway, since they are extremely illiquid and not followed by Wall Street.

Furthermore, what's coming down the pike in terms of future IPOs?  Let's look at Google, for example.  Everyone is making money on the shares which almost singlehandedly, along with Amazon and other uber-caps, are driving the indexes.  So, no one complains.

Since shareholders can't exercise their rights in Google because of the multiple share classes, they are not owners in the traditional sense.  Activism here has no meaning. The new tech companies have little need for massive capital investments, aside from those arising from pie-in-the-sky projects like driverless cars.  As such they should be poster children for returning cash to shareholders, but au contraire, they have little appetite for doing so.

None of this is lost on the investors and managements of Uber, Alibaba, and all the other supergiant companies that have to eventually become IPOs.  Investors can't continually raise the arbitrary valuations of these companies, and continue to pour in cash when it is becoming apparent that cash balances alone won't capture the growth they require for their current valuations.  Witness Uber and its battle with its Chinese nemesis.  So, if the next wave of IPOs is dominated by these kinds of companies, large cap funds of every stripe--tech sector, growth, new era---will all wind up owning the same companies while charging wildly different fees.

Meanwhile, retirees will need income but the pool of dividend paying companies is shrinking, with mergers being one reason.  They are also buying back their shares.

I get a headache thinking about this, but it is a real problem beyond the current fast food menu in financial journalism.  Keep an eye on this one, and I am doing some work on this for other reasons.

It is Labor Day weekend in the U.S.  Enjoy some time with your family and friends. Equity markets will open next week as usual.

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