As the bull market turns 8 years old it’s not only getting a bit long in the tooth, but valuations are beginning to be stretched. This has both market analysts and investors concerned not only about a sell-off, but that returns may be low for years to come.
A recent report from Credit Suisse, The Incredible Shrinking Universe of Stocks, takes deep dive into what has helped drive recent gains and may explain why current valuations might not be a concern.
The upshot is that, for a variety of reasons, the number of individual stock listings has declined sharply over the past two decades. However the size, age and profitability of those public companies has increased. This is a positive because it provides a steadier return. It is a negative because many investors are missing out on the early growth period of young businesses and the decline in volatility translates into a lack of opportunity to outperform the market.
Below are some key excerpts from the full report:
The U.S. public equity market has evolved dramatically over the past 40 years. This is important because the U.S. equity market is 53 percent of the global stock market as of December 31, 2016.1 The main feature of this change is a sharp fall in the number of listed equities since 1996, which was preceded by a steady rise in listings in the prior two decades.
As a result of this drop, there are fewer listed companies today than there were in 1976, despite the fact that the gross domestic product (GDP) is three times larger now than it was then. The Wilshire 5000 Total Market Index, established in the mid-1970s to capture the 5,000 or so stocks with readily available price data, now has only 3,816 stocks.
There are three reasons a company delists from an exchange. The first and most common is the company is involved in a merger or an acquisition. This can involve one public company buying another (Microsoft buys LinkedIn), a private company buying a public company (Dell buys EMC), or a company going private with the sponsorship of a private equity firm (Silver Lake acquires Dell). Second the exchange can force a company to delist for cause.
This means the company failed to meet certain requirements, including maintaining a minimum stock price and market capitalization, or was not current with the filings required by the Securities and Exchange Commission. Bankruptcy is another trigger for delisting for cause (Enron). Finally, a company may choose to delist voluntarily. Here, the firm judges that the cost of listing outstrips the benefit. The company may continue to trade but is no longer registered with an exchange.
Mergers & Acquisitions are the leading reason for delisting and as you can see the numbers have accelerated after the financial crisis.
All three reasons for delisting have the net effect of removing weaker companies, what’s left are those that are more stable and command a higher multiple.
IPOs are the most important source of new listings. Exhibit 7 shows the pattern of IPOs from 1976 to 2016, with a general uptrend from 1976 to 1996 followed by a decline since that time. The average number of IPOs was 282 per year from 1976 through 2000. Since then, the average has been 114.
Whereas the addition of new listings exceeded the subtraction of delistings from 1976 through 1996, the opposite has been true since the end of that period.
One potential explanation for the drop in IPOs is simply that business dynamism has been on the decline in the U.S. For example, 712,000 new establishments launched in the U.S. in 1996 and only 670,000 did so in 2016, despite the fact that today the GDP is almost 60 percent larger and there are 20 percent more people. Indeed, fewer new establishments were started in 2016 than in 1976. Establishments less than 1 year old created 4.4 million jobs in 1996 and around 3 million in 2015.29 The data suggest that eligible companies do not see a net benefit in listing via an IPO.
There are likely a few explanations for this; the cost to go public, the ability to raise larger amounts of capital through venture capital and private equity and private markets which allow employees to sell shares prior to an IPO.
Amazon.com went public 3 years after founding at a market capitalization of $625 million, in current dollars. Investors on the IPO have made 565 times their money. Google went public 6 years after founding at a value of $29 billion, and its investors have made 20 times their money. Facebook went public 8 years after its founding at a value of $110 billion, and investors have made 3.7 times their money. It is virtually impossible for Facebook investors to earn the same total shareholder return as Amazon.com shareholders did over 20 years.
All told, new IPOs tend to be companies that are more mature and profitable than in the past. But it also means the steepest part of their growth curve already curved.
Slicing the Same Pie
One way the void left by fewer individual equity listings is the explosion in a variety of related or derivative products. This ranges from options, volatility products and of course Exchange Traded Funds (ETFs). The ETF holds assets that typically track an index, stocks within a sector, stocks that exhibit certain factors, bonds, or commodities. In principle, the ETF is supposed to trade close to the net asset value of the securities it is tracking. About one-fifth of the assets under management for ETFs track traditional indexes such as the S&P 500.
As a result of all of the above, listed companies today are on average larger, older, and more profitable than they were 20 years ago. Further, they operate in industries that are generally more concentrated. The overall size and maturity of listed companies means they are more likely to pay out cash to shareholders in the form of dividends and share buybacks than companies were in the past. We speculate that the maturation of listed companies has also contributed to informational efficiency in the stock market. Gaining edge in older and well established businesses is likely more difficult than it is in young businesses with uncertain outlooks. In turn, the greater efficiency may be one of the catalysts for the shift that investors are making from active to indexed or rule-based strategies.
— The Option Specialist