Stocks have an almost mythical aura about them for many investors. Conceptually, stocks tend to produce higher returns than many other asset classes and therefore feature prominently in many retirement plans. Practically, stocks have provided terrific returns for many through their working years and into retirement.
The proposition of investing in stocks, however, has changed over the years. In many cases, perceptions have not kept up with this reality. As a result, many investors still consider stocks to be a “treasure,” while others are increasingly seeing them as “trash.”
To any analyst who follows publicly traded stocks, it is obvious that there are a lot fewer of them around than there used to be. A 2018 NBER report highlighted the phenomenon:
“There are fewer firms listed on U.S. exchanges than 40 years ago. In 1976, the United States had 4,943 firms listed on exchanges. By 2016, it had only 3,627 firms.” The report reveals that this decline is a fairly recent phenomenon. Having increased steadily through to the listing peak in 1997, the number of listed stocks has fallen sharply since then, as “the number of listings dropped every year since 1997, except for 2013.“
The reasons for the decline are also revealing. The single biggest reason has been the high level of merger and acquisition activity in recent years, but a slower pace of initial public offerings (IPOs) has also contributed. As a result of these coincident phenomena, “the size of listed firms has grown sharply.”
“The whole size distribution of listed firms has shifted so that average market capitalization and median market capitalization accounting for inflation increased by a factor of 10 from 1975 to 2015.“
Not only are public firms much larger than they used to be, fewer of them have long roads of growth still ahead of them.
This matters because stock returns are asymmetric. While you can lose all your investment, you can only lose the amount of that investment. On the other hand, it is possible to make many, many times the size of an original investment on the upside. As a result, it is quite possible that one or two big winners in a portfolio can more than compensate for several underperformers.
For this reason, the big winners over time have become legendary for their contributions to outperformance. Tom Braithwaite touched on this in the Financial Times where he recounted the example of Cisco going public in 1990 with less than $100m of revenues. It then went on to become the first company to reach $500bn of market capitalization. Early investors in Microsoft, Apple and Amazon had similar experiences. Just one or two of these stocks could overcome a lot of weak performers in a portfolio.
Recent vintage IPOs, however, are featuring companies that mostly have waited much longer to go public and therefore afford less opportunity for growth for public shareholders. Braithwaite notes, “Today, with the help of a vast influx of sovereign wealth money and mutual funds not wanting to overpay at IPO, companies can delay until they are big enough to command the sort of valuation that Snap achieved this year $20bn.”
The recent IPO of Uber is emblematic of the trend. Just ahead of its IPO, the company reported revenues of $11.27 billion in 2018, a level that amounts to over 110 times as much as Cisco had when it went public.
As the Uber example also plainly reveals, when firms go public today, they are increasingly doing so without any profits to show. While the companies that do IPO may be leaders in their field, they are still unseasoned and subject to substantial risks. The FT reported on a study by Jay Ritter, a business professor at the University of Florida, which noted,
“in 1980 only 25 per cent of US companies had negative earnings when they came to market. Last year, it was 80 per cent.“
The trend in lack of profitability has also permeated the markets more broadly. To be sure, it is normal that some group of companies will be unprofitable for various reasons such as cyclical downturns, idiosyncratic events, or new business launches. However, the NBER report shows that the current prevalence of unprofitable companies is unusually high:
“The fraction of firms with earnings losses in a given year has increased substantially. In 1975, 13 percent of firms had losses. In contrast, 37 percent of firms had losses in 2016.“
All of this has led to a market that is considerably more concentrated than it used to be. The NBER report continued:
“As a result, earnings have become more concentrated. In 2015, the top 200 firms by earnings had total earnings exceeding the total earnings of all public firms combined. In other words, the total earnings of the 3,281 firms that were not in the top 200 firms by earnings were negative.”
The net result is an almost shocking lack of diversity of profits.
In aggregate, the data reveal striking changes in the composition of the market. There are a lot fewer public companies to choose from, a much higher proportion of them lose money, IPOs don’t provide anywhere near the same type of upside potential, and aggregate earnings are massively concentrated. In short, the Economist reports,
“A smaller number of older, bigger firms dominate bourses.”
Many of the compositional changes also go hand in hand with a weaker competitive landscape. The Economist highlighted the persistence of unusually high profits as one important signal of trouble:
“High profits across a whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning off wealth than creating it afresh, such as those that exploit monopolies. If companies capture more profits than they can spend, it can lead to a shortfall of demand.” Rising profits, then, “coupled with an increasing concentration of ownership … means the fruits of economic growth are being hoarded.”
There are plenty of other signs of weaker competitive conditions if one cares to look. For example, one would expect relatively high returns in an uncompetitive economy and lower returns in a very competitive one. The data reflect poorly on US businesses:
“Though American companies now make a fifth of their profits abroad, their naughty secret is that their return-on-equity is 40% higher at home.”
In addition, there are indications that competition has also been stunted by way of laws and regulations. The Economist notes that “business spending on lobbying doubled over the period [1997 to 2012] as incumbents sought to shape regulations in ways that suited them.” Sometimes, big firms have simply leveraged their ability to “influence and navigate an ever-expanding rule book.
“Regardless, the effect has been to reduce “the rate of small company creation in America … close to its lowest mark since the 1970s.”
Weaker competition gets manifested in other ways too. “In some industries – banking is a case in point – rent-seeking will result in high pay to an employee elite instead.” Sometimes lower accountability results. Historically, when chief executives have gotten sacked, it has been for poor performance. More recently, however, the FT reports that an unusually high “39 percent of departures of chief executives] were due to ethical issues.”
A good summary of the trend comes from another NBER report: “After 2000 … the evidence suggests inefficient concentration, decreasing competition and increasing barriers to entry, as leaders become more entrenched and concentration is associated with lower investment, higher prices and lower productivity growth.”
“The obvious conclusion,” the Economist reports, “is that the American economy is too cosy for incumbents.” For all the legendary importance of Adam Smith’s “invisible hand” of competition, the report states that it is “oddly idle” in America. As a result, power has shifted from away from shareholders of public companies.
“In the 20th century, it was often assumed that public markets were the epitome of financial capitalism; indeed, the idea was so deeply ingrained that policymakers and financiers tended to assume that financial evolution went in one direction: from private to public.
But today the trend towards private finance is being driven by ‘pull’ and ‘push’ factors. On the one hand, private equity, real estate and debt investments have often offered better returns than public equity in the past decade … At the same time, the raison d’etre for public markets is faltering. They used to be seen as a more democratic and inclusive form of capitalism.“
The Economist also addresses similar issues.
“Mr Mauboussin notes that 40 years ago a pension fund could get full exposure to the economy by owning the S&P 500 index and betting on a venture-capital fund to capture returns from startups. Now a fund needs to make lots of investments in private firms and in opaque vehicles that generate fees for bankers and advisers. “
As a result, according to the FT:
“Ordinary Americans are being deprived of opportunities to invest early in the next big winners … But only wealthy individuals can invest in individual private companies before the IPO.” In other words, the opportunities that used to be shared widely across public markets are now the reserve of the privileged few.
One can argue that the democratic aspect of public markets is more than just challenged; in many ways a mockery is being made of it. Steve Case, the founder of AOL and CEO of Revolution, a venture capital company, noted in the FT, “companies used to go public to actually raise operating capital.” Since companies needed scarce capital in order to grow, raising that capital normally sent a signal that attractive growth potential existed.
Now, however, “the goal of an IPO is all too often for investors to ‘exit’ with as high a valuation as possible.” As such the signal provided by an IPO is almost exactly the opposite. Now an IPO signals the end of a growth thrust, not the beginning of one, and it is pawned off on the least discriminating of investors, i.e., public ones.
These insights facilitate a vastly different narrative for the stock market. What was once a reasonably accessible and diversified universe of companies that provided good exposure to a strong economy has now devolved into something considerably less attractive. Now the universe is comprised of a combination of old companies trying to hive off the greatest possible profits from dying industries and younger companies taking flyers on unproven and unprofitable businesses with shareholder money.
Additionally, given that these changes have occurred at the same time as passively managed funds have massively increased their share of the market, it is hard to escape the possibility that passive investing has at least exacerbated some of these developments. The lack of meaningful pushback by passive shareholders against management teams creates a vacuum of accountability from which many forms of bad behavior can thrive.
In light of all the changes that have occurred in the stock market over the last few decades, it is very fair to say that it is much less attractive than it used to be. But it is also possible to speculate further. What if public stocks now are the leftovers, the dregs that nobody else wants? What if public stocks have become the detritus of the investment world?
To be fair, the claim is extreme. There are still good public companies out there, although many of the stocks are overvalued. Nonetheless, such a consideration has significant implications for investors.
One is that things change. As attractive as stocks may have been forty years ago, they represent a different proposition today, especially at today’s record high valuations. As such, it does not make sense to treat them as static entities in a portfolio context.
Relatedly, the constantly changing market creates an opportunity for active management and a risk for passive management. As history shows in abundance, stock returns are not magical entitlements. Some periods are great while others are devastating. Investors who do not adapt to changing conditions put themselves at great risk.
Finally, part of the aura associated with public markets has been due to their strong link with the economy. As the NBER report states, however,
“Large firms no longer employ all that many people in America: The domestic employee base of the S&P 500 is only around a tenth of total American employment.”
As a result, the real economic impact of public firms has moderated considerably. Investors now need to consider a broader set of signals in order to get a good pulse on the overall economy.
So, time flies, things change, and investors have a choice. They can either look backwards and revel in the “glory days” of stocks or they can adapt to a new reality in which publicly traded stocks are just far less attractive than they used to be. Things will change again and someday there will be another golden age for stocks. For now, however, it is best to be extremely discriminating.