The Incredible Shrinking Market
Exchanges have seen a dramatic decrease in listings, but that’s about to change.
According to Wilshire Associates, the number of listed companies on U.S. stock exchanges has dropped by 47 percent since 1997. This year only 3,927 companies are listed on the NASDAQ and NYSE. In contrast, the number of companies listed in 1997 tallied 7,459.
Similarly, it’s been more than 30 years since the number of companies included in the Wilshire 5000 index fell below 4,000 when - in 1979 - the number hit 3,715. The Figure 1 shows the trend.
Figure 1: The Number of Stocks in the Wilshire 5000 Index
There are several reasons for the drop in listed companies:
- Mergers and acquisitions have reduced the number of listed companies by 2,000.
- Increased government regulation has increased the cost and reduced the attractiveness of listing on a U.S. exchange. A growing trend for U.S. companies has been to issue shares only on foreign exchanges and not in the U.S.
- More than 7,000 companies have been delisted from exchanges since 1997. About 5,000 of those delisted companies were forced to delist for not meeting exchange requirements on minimum price, capitalization and trading volume. In fact, delisting was so common in 2008 that NASDAQ suspended its requirements in an attempt to slow the trend.
- Low equity valuations – coupled with low interest rates – have made bank borrowing and private transactions a more attractive option for raising capital than through an initial public offering (IPO). The number of companies raising capital through an IPO dropped more than 70 percent since 1997, from an average of about 450 annually to less than 100 annually.
When you consider this decrease in listings, you have to wonder what the implications are. I think they’re very good for U.S. stock investors.
The recovering U.S. economy is driving corporate earnings higher which is driving stock prices higher. The market is still not high enough to interest private companies however. They’d still rather borrow money or raise it through private equity or a merger than do an IPO, a strong signal that stocks are cheap – relative to interest rates and private valuations.
This low valuation can’t last.
Corporations and private equity investors are aggressively hunting for companies. There’s been a big jump in mergers and acquisitions (M&A) so far in 2011, with worldwide deals worth $83 billion already announced. That’s up from $67 billion in the same period last year as reported by the Financial Times.
Deals in 2010 totaled $2.8 trillion, up 23% from $2.3 trillion in 2009, according to The Economist. In 2007, the all-time record for merger deals in a single year was $4.3 trillion, according to Dealogic. That's the same year the stock market hit an all-time high.
Today cash mergers – not stock mergers – are being done more frequently. Cash is cheap. Companies borrow at 3 percent plus to buy a company with a PE of 15, which results in an earnings yield of 6.7 percent. That’s a good deal, and private equity knows it.
Just put yourself in the owner’s seat of a private company that’s looking for capital. If you’re able to borrow at a low interest rate or sell privately at an attractive price, then that’s what you’re going to do. If you can get a better price by doing an IPO, then that’s what you’re going to do. It’s good business management.
Low public market valuations are keeping the IPO market muted, but that won’t last much longer. There’s too much cash on the sidelines in the accounts of corporations seeking to grow and institutional investors seeking higher returns on their funds. A cash infusion would drive stock market valuations higher, assuming the recovery continues. This in turn would attract equity mutual fund investors, creating the environment needed for a substantial increase in IPO activity.
Wall Street investment bankers are already preparing for a surge in IPOs by hiring people and targeting companies. They’ve also been aggressively baiting the media with juicy stories about a potential IPO at big names such as Facebook, LinkedIn and Groupon. When one of these companies successfully launch, I believe the IPO market will be off to the races and the uptrend will last for many years.
Another interesting phenomenon is the mutual fund market. While listed stocks have dropped by nearly 50 percent over 14 years, the number of U.S. equity mutual funds and ETFs that hold these stocks have increased more than 60 percent. We’ve finally hit the point where there are more mutual funds and ETFs investing in U.S. equities than there are U.S. equities. Morningstar Principia lists about 4,200 distinct domestic equity mutual funds and ETFs in 2011. That’s up from about 2,600 in 1997.
I bring up the surge in the number funds because there are 4,200 fund managers acting as cheerleaders for higher stock prices, and they’re all over the media. When the public finally realizes that the economy is recovering and that higher stock prices are not an aberration, they’ll warm up to owning stocks again, and that will push valuations higher.