Have equities gone ex-growth? Certainly, recent growth has been unimpressive. In the last five years the earnings per share of FTSE 100 companies have shrunk in real terms, and even the growth of the more dynamic mid-cap sector has been below average.
This isn’t entirely due to lacklustre growth in the world economy. Instead, it might reflect a more troubling longer-term trend: the stock market is no longer the place to find fast-growing companies.
Companies across the developed world are increasingly avoiding the stock market. Fewer are coming to the market and those that are already on it are buying back their own shares or even delisting completely. Kathleen Kahle at the University of Arizona and Rene Stulz at Ohio State University have shown that in the US the number of listed companies has fallen sharply since the 1970s, and those that are listed are bigger and older than they were then and are less profitable and hold more cash. In the UK the number of companies listed on the main market has dropped from 1,747 to 1,156 since the start of the century. Bank of England data show that UK non-financial companies have raised only £12.1bn from new share issues in the last five years while ONS data show that they have bought back £113.8bn of them in this period. Why?
Some say it is because low bond yields are causing companies to use debt rather than equity finance.
High economic theory, however, says this cannot be. The Miller-Modigliani theorem says that (under particular conditions) the value of a company shouldn’t be affected by how it is financed. If equity finance seems expensive to companies it is because investors think the companies are risky – in which case it is dangerous to load up on debt. It is only* if the market is wrongly underpricing shares (thus making equity finance expensive) that it makes sense for companies to prefer debt finance. While this might be true today, it is unlikely to have been true for the whole of the last decade.
Instead, there are other reasons why companies aren’t using equity finance. One is simply that many don’t need to, as they are generating cash and not investing. Bank of England data show that non-financial companies’ cash holdings have risen by over 70 per cent in the last eight years. Another reason, says Schroders' Duncan Lamont, is that some company managers don’t want the hassle, publicity and (they believe, perhaps wrongly) pressure to hit short-term earnings targets that result from being listed.
Something else, though, is going on – which should worry equity investors. It’s that a stock market listing with large numbers of small dispersed shareholders is no longer the right form of ownership for many companies.
In truth, this is an old problem. Way back in 1848 John Stuart Mill noted that managers of listed companies were apt to neglect shareholders’ interests. And this problem has never been adequately solved. This is partly because of a free-rider problem. With hundreds of outside shareholders each one has an incentive to piggy-back on others’ efforts to oversee management. Everybody therefore hopes that somebody else will be the active investor, with the result that nobody is.
Such a form of ownership is okay for companies that have lots of potentially profitable projects but little cash. But as the Nobel laureate Michael Jensen pointed out in a classic paper in 1989, it is not suitable for companies facing slow growth or that have lots of cash and few good investment opportunities. And in a world of secular stagnation there are more of these and fewer companies with lots of profitable options. It’s no disaster if poor oversight of managers causes them to select projects with a 20 rather than 30 per cent return on capital, but it is a problem if companies must choose between projects with a plus 5 or minus 5 per cent return.
For more and more companies, therefore, private equity is a better structure. This avoids the free-rider problem – where there is one owner, he has an incentive to monitor management better. And many private equity managers have specialist knowledge with which to help those managers, whereas outside shareholders can be just a hindrance.
And with private equity funds getting bigger, companies can raise more from them and so have less need to float on the market.
All this raises a problem for equity investors. Companies that are listed on the market might be an unrepresentatively bad sample of all the companies there are, as they are less likely to grow nicely. Worse still, companies are often floated on the market at the peak of their fortunes, as their owners try to cash out, with the result that they underperform. Jay Ritter at the University of Florida has shown that, for years, newly floated stocks do badly in the first three years after they are listed. And there’s no sign of this tendency diminishing, as investors in Saga, Pets at Home or Royal Mail know to their cost.
Luckily, though, we have a simple answer to this problem. We should hold private equity funds as well as quoted stocks.
*It's also the case that debt interest payments are tax-deductible which gives companies an incentive to issue debt. This advantage, however, has declined as tax rates have fallen and so cannot explain the increased reluctance to use equity finance.
