Publicly traded U.S. companies have by no means vanished, but their numbers have thinned out precipitously since the end of the last century. According to the World Federation of Exchanges, listed companies on major U.S. stock exchanges peaked at nearly 9,000 in 1997, then declined steadily to fewer than 5,000 in 2012. That’s a 44% drop in 15 years.
Will such a slide continue? And even if it does, so what? Does it really matter to financial advisors and their clients if there are 5,000 American companies in which they can invest, rather than 9,000? The answer may be a matter of perception, depending on whether an advisor is looking at the pitcher of U.S. stocks as being half full or half empty.
Deciphering The Decline
One of the reasons for the plunge is that some listed companies no longer trade while the supply of newcomers has failed to fill the gap.
“The key to that decline statistic is the beginning year of 1997,” says James (Chip) Dennedy, principal at REDW Stanley Financial Advisors in Albuquerque, N.M. “That was in the middle of the Internet bubble, when unprofitable dot-coms were being introduced every day. Many of these have gone by the wayside, while some with decent ideas were gobbled up by more viable companies.”
Kathleen Shelton Smith, principal at Renaissance Capital, an IPO investment advisory firm in Greenwich, Conn., lists a few other reasons that companies have left American exchanges. “Many companies, weakened by the current economy, have chosen to go private and delist,” she says. “Others have sold out to bigger companies. In addition, some foreign companies have delisted or been less likely to list in the U.S. market as other exchanges, such as Hong Kong, have evolved to become a more liquid alternative to listing in the U.S.”
What’s more, the flow of IPOs has slowed from the torrents of the 1990s to a trickle now. The Trader’s Narrative Web site, using data from the University of Florida, shows that there were at least 280 IPOs in the U.S. every year from 1991 through 2000. The peak year was 1996, when there were 675 IPOs.
In this century, IPOs declined steadily until 2008, the year the financial crisis hit, when Trader’s Narrative shows only 20 new offerings. Even though IPO activity has picked up since then, Renaissance Capital reports that only 125 deals were done in 2011 and only 99 more in the first three quarters of 2012.
“We believe the decline in the IPO market is primarily related to poor equity returns and high volatility over the past 12 years,” says Smith, “causing investors to seek alternative asset classes that are less volatile and more lucrative in the current easy money environment.” She cites high-yield bonds, real estate and commodities as examples.
“Poor equity returns and volatility scare away long-term investors,” Smith continues, “resulting in fewer investors to be interested in IPOs and, therefore, low issuance.” Smith also contends that short-term, high-frequency traders have hurt the integrity of the U.S. equity markets, making new issuance very challenging to float. “Yet our regulators have been slow to address this problem,” she says.
Some factors point to a continued fall in the number of U.S. public companies. “The introduction of Sarbanes-Oxley and the increase in accounting standards for public companies have compelled more companies to stay private,” says Paul Madrid, trading and investment manager at REDW Stanley Financial Advisors. Public companies have to deal with ample oversight and regulation.
“Especially for companies with relatively small market caps, Sarbanes-Oxley can be extremely onerous,” says Charlie Smith, principal and chief investment officer at Fort Pitt Capital Group in Pittsburgh. This legislation, passed in 2002 in the wake of several highly publicized scandals (like the ones at Enron and WorldCom), boosted the regulatory costs imposed on public companies.
“For a small company,” says Smith, who is also the portfolio manager of the Fort Pitt Capital Total Return Fund, “the potential costs of compliance could be several hundred thousand dollars a year. For some companies, where the profit margin might not be all that great, such added costs could be a serious impediment.”
Dick Dickson, senior market strategist at Lowry Research in Palm Beach Gardens, Fla., agrees that increased regulation could hold down the number of public companies. “New regulations are driving some firms not to list,” he says, “or to list on foreign exchanges, where the costs aren’t as steep. It’s entirely possible that if Sarbanes-Oxley and Dodd-Frank remain the law of the land, more people will decide to stay private with their companies. There is ample capital available for such companies now. With more risk and less reward, going public is not as appealing as it was in the past.”
Perks Of Going Public
Yet it is by no means certain that U.S. public companies will go the way of the hadrosaur. In a recent article at Knowledge@Wharton, a Wharton School Web site, professors Richard Herring and Alex Edmans asked if there would be “A Premature Eulogy for Public Companies?” The authors argue that public markets offer benefits that private equity cannot match, such as transparency, liquidity and easy access for small investors.
A public company has more owners than a private firm, the article points out. “Hence, public ownership can muffle the cries of a minority of unhappy shareholders, making life easier for managers rather than harder.” The authors conclude that the decline in public company listings could be reversed if Washington eases regulatory burdens, the economy picks up and the financial markets return to normal. In fact, as Charlie Smith points out, “The JOBS [Jumpstart Our Business Startups] Act, passed in 2012, contains provisions meant to address some of these issues.” (The JOBS act allows companies to avoid complying with some Sarbanes-Oxley accounting requirements if the companies’ annual revenues stay under $1 billion.)
Chris Beck, co-manager of the Delaware Small Cap Value Fund, says that he doesn’t expect a huge increase in the number of public companies in the future, but he doesn’t foresee a sharp decline either. “Some public companies will be acquired,” he says, “reducing the number, but others will go public. Going public is still the best way for private companies to raise cash and the best way for private equity firms to profit from their investments.”
Assuming that the number of public companies continues to drop, what might be the eventual impact on financial advisors and investors? One possibility is that there will be a reduction in the pool of investable companies, which will increase stock market volatility, especially in the small-cap sector. Increased volatility, in turn, could lead to reduced allocations to U.S. equities.
But the result could also be positive: the survival of the fittest. The listed companies that remain could be profitable enough to manage the added costs and savvy enough to handle the increased pressures of public scrutiny. That could justify an investor’s greater exposure to U.S. equities.
“I would agree with survival of the fittest,” says Dennedy. “The financial crisis dried up the market for IPOs for a few years, with only the very strongest profitable companies venturing into the IPO market. The last couple years have been a bit of an exception, with companies such as Groupon, Zynga and Facebook going public. These are viable companies, but were overpriced at the IPO. Except for a few social media companies, most public companies are very strong, reasonably priced and adapting well to changing economic pressures.”
Beck says the decline allows him to eliminate companies he wouldn’t look at anyway. The ones left are better quality companies, he asserts, and he has a sufficient quantity of stocks to choose from for his small-cap value fund.
Charlie Smith has a darker view of listed stocks’ disappearance. “I don’t see significant positives from a decline in the number of public companies,” he says. “A healthy small- and mid-cap public market is good for the entire stock market. Any lessening is a negative. Advisors need to be even more careful when looking at micro caps. If there are not as many, the market may have liquidity restraints.”
Dickson agrees that a shrinking pool of investable companies could lead to a problem with liquidity. A reduction in the pool of investable companies, leading to greater volatility, could diminish buyers’ appetite for such stocks and the prices they’re willing to pay.
“Say you build up a large position in a small stock so you want to sell and take profits,” he explains. “But the question is, to who are you going to sell, at what price? With a smaller universe, you have fewer choices. Local companies, with regional firms making a market, may be especially vulnerable.”
What’s more, the lack of liquidity may not be confined to small caps. Among many “listed” issues are preferred stocks, convertibles, derivatives and closed-end funds. “Often, they’re thinly traded,” Dickson says. In fact, there might be more than 3,000 issues on the New York Stock Exchange, but more than half are not the common stocks of operating companies, he says. “That percentage has been creeping up over the years. Again, the shrinkage can cause liquidity problems.”
Moreover, the decline in the number of public companies is not taking place in a vacuum. Other factors have also led to increased stock market volatility. Dickson cites the spread of high-frequency traders, the elimination of the uptick rule and the decline in the role of specialists in the equities markets. Together with a reduced number of traded operating companies, “Volatility might go through the roof,” he says.
But is volatility really that meaningful to financial advisors who build clients’ asset allocations for long-term results? “At some point, all investors are short term,” Dickson says. That’s the case when clients are ready to retire, for example.
“And even long-term investors can reach the point where they can’t stand the pain of a falling stock market,” he says.
“History shows that many people sell at the bottom. The potential for volatility has not changed since the May 2010 ‘flash crash.’ Advisors must be able to explain that to their clients.”