In our new COVID world, it is normal to see shortages throughout the economy. Near empty car lots, and grocery shelves that don’t always have what you need are now common. There is also another shortage that has been in the works for almost 25 years, virtually unnoticed. The stock market is shrinking.
You read that right!
So, what do I mean when I say the stock market is shrinking? It is getting smaller in two ways. First, there are simply fewer publicly traded stocks in the U.S. Second, publicly traded companies are buying back more of their shares than ever, which reduces the shares available for investors to purchase. The question then becomes not only why the market is shrinking, but what are the long-term ramifications to investors?
Fewer Publicly Traded Companies
At its peak in 1996, there were more than 8,000 publicly traded companies in the United States. By the start of 2020, that number was around 5,000. This long-term decline has been the result of a host of different issues.
First, as interest rates have declined for the past 30+ years, the number of corporate acquisitions has increased – lower interest rates have allowed corporations to pay more in order to buy other publicly traded companies. This is no different than a lower mortgage rate allowing a prospective home buyer to purchase a more expensive home with the same monthly payment. Home values tend to go up with lower mortgage rates. Its no different with corporations.
The second development that has led to a smaller aggregate number of publicly traded companies is the growth of both private equity and venture capital. Thirty years ago, if a private business wanted access to the capital required to grow, the best source of the needed capital was through an initial public offering, or IPO. Access to public markets entails extensive underwriting costs and the ongoing reporting, and the compliance issues associated with being a public entity.
The Sarbanes-Oxley Act of 2002, for example, placed many compliance and administrative rules on public companies (thanks, Enron). All public companies are required to implement, document and test internal controls over their financial reporting at all levels of the organization. Some argue that the focus around quarterly earnings tends to reduce management’s focus on longer term goals in an effort to not disappoint the analysts’ short-term earnings expectations.
All of the aforementioned headaches were just the cost of doing business – until the boom of capital available with both venture capital and private equity. A smaller company could now get the much-needed capital for growth without the pains associated with going public. This process is much faster, and it does not involve the same costs associated with an IPO, (much less the compliance issues that may arise too).
A private company with a valuation of $1 billion or more was lovingly called a unicorn. As the name implies, it was a rare sighting. In 2013, there were an estimated 39 of these corporate unicorns worldwide. Today, that number is north of 900! As you can see, it is very possible to have dramatic growth without accessing the public markets to finance that growth.
The growth of corporations buying back their own shares has also gained traction. Every CEO is concerned about their earnings per share (EPS), since the valuation of their stock is usually tied directly to EPS. Earnings per share is simply earnings divided by the number of shares outstanding. Simple math dictates there are two ways to make earnings per share increase: increase the numerator (earnings), or decrease the denominator (shares outstanding).
Murky enough for you?
Think of it this way – existing shareholders own a larger percentage of the company after a share buyback without doing anything. In 2021 alone, public companies spent more than $850 billion repurchasing their own shares. Interestingly enough, almost every year since 2004 has seen S&P 500 companies spend more on their own share buybacks than on paying dividends to their shareholders.
One clear example of a company that has been buying their own shares on the open market is Apple. At the beginning of 2013, Apple had 26.3 billion shares outstanding. From that point up until today, Apple has consistently repurchased their shares on the open market, inevitably putting those shares to “retired” status. Fast forward to today and Apple has 16.3 billion shares outstanding.
While Apple’s market capitalization (shares outstanding multiplied by price-per-share) has increased from $495 billion in the beginning of 2013 to its current capitalization of $2.69 trillion, there are 38% less Apple shares available to purchase. Unsurprisingly, Apple isn’t alone – many other companies have seen significant reduction in their shares outstanding including blue-chip names like: J.P. Morgan, Oracle, Home Depot, Pfizer, Microsoft, Wells Fargo and Johnson & Johnson.
We are not saying that all share buybacks, mergers, acquisitions, and private equity and venture capital deals are great for long-term shareholder value. Like any transaction, there are some that are very good and some that are awful for shareholders.
Ramifications for the Market
The most obvious impact from these changes is the average public company is going to be larger than 20 or 30 years ago. Less private smaller companies using the public market to fund their growth, and more merger and acquisitions will lead to a smaller number of stocks available to invest in. However, the remaining stocks will be larger. Some of the best small companies in American may never go public. Those small companies with the most exciting prospects will be swallowed up from private investors, never giving the public investor a chance to benefit. The return of smaller capitalization equity markets historically has been greater than that of the large stock indices. That return discrepancy may change over the next 30 years.
Another long-term ramification is one of the greatest arguments against both acquisitions and share buybacks: the massive use of debt to fund those transactions. The higher the debt load of any business, the more difficult it is to weather difficult times. So, taking out massive loans to either buy another company or repurchase massive amounts of their own stock, there is less financial flexibility when a cash infusion may be needed. The end result: the next time we have a terrible recession, there may be more instability and bankruptcies. In the end, when a company takes too much risk, and their timing is not good, it will end poorly.
Another change we could see revolves around financial transparency. The more large corporations we have that remain private (remember the unicorns), the less data we have to determine the true strength of the economy. The reporting requirements of the major stock exchanges gives us valuable insights on the true strength, or weakness, of these public companies.
A large part of the economy in other words, is going dark when it comes to financial transparency. Remember the phrase used to describe many financial firms back in 2008; too big to fail. We are starting to see a growing number of large private companies that have a large impact on the overall economy. Don’t be surprised if, at some point, the U.S. Government gets involved and requires some form of regular financial reporting from larger private companies. Given the complexity of some of these organizations, this might not be as bad of an idea as it once was.
Finally, the law of supply and demand will still be in place. In 1996, the U.S. population was 269.4 million. Today, that number is 329.5 million, or a 22% increase. Moving forward, we will have more people investing in the stock market, either through traditional investment accounts and through their company retirement plan. It this trend of a shrinking stock market continues; we will have more dollars chasing fewer stocks available to purchase.
This has and will always leads to higher valuations.
Associate Managing Director, Wealth Management