Check out two abstracts of papers by Rene Stulz and others.
Eclipse of the Public Corporation or Eclipse of the Public Markets?
Since reaching a peak in 1997, the number of listed firms in the U.S. has fallen in every year but one. During this same period, public firms have been net purchasers of $3.6 trillion of equity (in 2015 dollars) rather than net issuers. The propensity to be listed is lower across all firm size groups, but more so among firms with less than 5,000 employees. Relative to other countries, the U.S. now has abnormally few listed firms. Because markets have become unattractive to small firms, existing listed firms are larger and older. We argue that the importance of intangible investment has grown but that public markets are not well-suited for young, R&D-intensive companies. Since there is abundant capital available to such firms without going public, they have little incentive to do so until they reach the point in their lifecycle where they focus more on payouts than on raising capital.
Why has Idiosyncratic Risk been Historically Low in Recent Years?
Since 1965, average idiosyncratic risk (IR) has never been lower than in recent years. In contrast to the high IR in the late 1990s that has drawn considerable attention in the literature, average market-model IR is 44% lower in 2013-2017 than in 1996-2000. Macroeconomic variables help explain why IR is lower, but using only macroeconomic variables leads to large prediction errors compared to using only firm-level variables. As a result of the dramatic change in the number and composition of listed firms since the late 1990s, listed firms are larger and older. Larger and older firms have lower idiosyncratic risk. Models that use firm characteristics to predict firm-level idiosyncratic risk estimated over 1963-2012 can largely or completely explain why IR is low over 2013-2017. The same changes that bring about historically low IR lead to unusually high market-model R-squareds.
These reminded me of my “narrower, deeper, older” observation of hobbies, such as Israeli dancing. People are being more selective about hobbies. Each hobby has a narrower base of participants. They are deeper into the hobby. And if the hobby has been around for a while, the participants tend to be older.
This seems to describe the public stock market in the U.S. Companies are being more selective about whether or not to use the public market. The public market has a narrower base of companies participating. The participants tend to have higher market capitalizations. They have been around longer.
Three major factors. Pre the tax reform bill this year, public companies paid a much higher tax rate, especially if they were largely domestic (as most smaller companies are).
Second, with regulation and especially Sarbanes Oxely, which hit around 2000, there is a certain high fixed cost to going public. Third, with private equity and venture funds, often funded by endowments and SWFs, there is plenty of money without going public.
So, going public made you pay more in tax (and buying back stock was only tax effecient way to return money to shareholders), increased your costs (especially for smaller firms) and could achieve the same ends without going public (venture funds and private equity). I am shoched fewer companies went public.
Tax reform changed one of those factors. It will be interesting see what impact that has
In general, only C corporations can participate in the public equity markets. That is virtually the only reason a business entity would choose to be a C corporation instead of an S corporation or LLC. For someone starting a profit-making business today it is rare to choose a C corporation as the form of entity. Although the tax reform bill lowered the corporate tax rate it did not eliminate it, and the bill also created significant new tax advantages for pass-through entities. So if growing companies can raise adequate capital without going public the number of publicly traded C corporations will continue to decrease.
It seems to me that the public can be duped into “pre-ordering” products instead of buying stock. Of course if there aren’t enough “pre-orders” then they still lose their money. If there are lots and the products do well, then the owners of the company get better results. There are advantages to the public in that the initial outlay is less, and all the professions and taxes involved in a stock offering are out of the loop. The unit cost of products are therefore potentially lower.
Another phenomenon in competition with stock markets is crowd funding, which is often similar as there are various rewards involved for those who stake certain amounts. Similar to this is cryptocurrency initial coin offerings, where cryptocoins are used to buy products if they do well.
I wonder if this can explain why corporate bond spreads (which include idiosyncratic risk) are low while the equity risk premium (which measures systematic risk and not idiosyncratic risk, according to CAPM) is high.
Stocks aren’t a market, there is nothing market about them except they are a form of legal structure utilizing shareholder separation.
Right? If I have inside information on farm products,the I go to farmer product companies and buy their stock against sellers of their stock. No market, just locate the companies.
There is nothing that makes ‘stocks’ a flea market on Wall Street except the flea market on Wall Street is a result of the government banking and debt industry, a legal agglomeration, not an aggregate of economic agents. The only economic activity managed by the ‘stock market’ is parceling out the cost of government regulation.
As a result of the dramatic change in the number and composition of listed firms since the late 1990s, listed firms are larger and older. Larger and older firms have lower idiosyncratic risk.
One aspect that is really changed is the last 40 years is the idea that both marginal and average cost for most companies evidently rises on output. (Except for the electric comany etc. I remembered he worked on the California electric deregulation at the time as well.) I remember a conservative Econ professor argue that was not necessarily true in 1993 and I believe that has come more true with more tech and digital information.
Look at Amazon or other companies in which the marginal cost of a bit is still small and decrease for extended output. Even in non-technology markets, such as Chicken Distributing, how much of buying, pricing and distribution is driven by technology improvements and productivity to where it is very hard for a new entrant with massive technology investment. (I suspect the one issue of tech investment is that the code is worth a lot or next to nothing if the investment fails.)
Otherwise, I think a lot growing companies are afraid to go public (or they are like Facebook that controls the stock) because shareholder goals can be at odds with a long term healthy company.