Now You See Them, Now You Don’t

Now You See Them, Now You Don’t

Each semester there are usually one or two out of about 120 students in my various accounting classes who are interested in the course because they either want to start investing or are investing and want to understand what they are doing.

It is rather sobering for me to tell them about the Efficient Market Theory that says that no one can consistently beat the market so their study of accounting to make themselves better investors may, unfortunately, not prove to be as fruitful as they expected.

The challenge of investment analysis and “stock picking” is compounded by the declining number of public companies in which to invest, which has the further unintended consequence of making historical statistics somewhat irrelevant. There were 7,355 US public companies in November 1997 according to the Center for Research in Security Prices at the University of Chicago’s Booth School of Business. Nowadays there are fewer than 3,600 per Jason Zweig, one of my favorite writers in The Wall Street Journal.

According to the Center for Research in Security Prices, there were more than 2,500 small cap stocks and nearly 4,000 “microcap” stocks in November 1997. At the end of 2016, fewer than 1,200 small stocks and just under 1,900 microcap stocks were left as reported by Zweig. Several factors spell out the shrinking number of stocks according to Zweig including the regulatory red tape that discourages smaller companies from going and staying public, the flood of venture capital funding that enables young companies to stay private longer, and the rise of private equity funds, whose buyouts take shares off the public market.

“The companies that have survived have tended to be fewer, bigger, older, more profitable, and easier to analyze making stock picking much more competitive” wrote Michael Mauboussin in the same article with Zweig. Mauboussin is an investment strategist at Credit Suisse Group AG in New York who wrote a report this past spring titled “The Incredible Shrinking Universe of Stocks.”

Consider small-stock funds. Often, they compare themselves with the Russell 2000, an index of the U.S. stocks ranked 1,001 through 3,000 by total market value. “Twenty years ago, there were over 4,000 stocks smaller than the inclusion cutoff for the Russell 2000”, wrote Lubos Pastor, a finance professor at the University of Chicago. “That number is down to less than 1,000 today.”

So what is an investor to do?

I asked Riley the Golden Retriever with whom I share an office. She looked at me and rolled over on her back for a tummy rub. Ah Riley, you are so right! Stick with the simple things that are easy to understand. So that is why my equity investments are in ETFs which tend to follow the S&P 500. It also helps that ETF’s have lower internal management costs than mutual funds. The S&P 500 is an index of the 500 largest stocks based on the market capitalizations of 500 large companies having common stock listed on the largest American stock exchanges. For dividend-focused equity ETFs, the choice again is stocks with long histories of consistently raising dividends – which are inevitably included in the S&P 500 list as well.

The fact that the number of publicly traded companies is declining is worrisome. Like many things these days, the regulatory effort to protect investors from every possible and conceivable risk has had the unintended and unfortunate side effect of shrinking the investment universe in which wealth can be created and grown.

This is not good.

We hear about the Silicon Valley Titans who sit atop large public companies. Those companies create large numbers of jobs directly and indirectly. Those companies were small once. With fewer smaller companies going public, the opportunity for growth and wealth creation in which employees and investors can participate is reduced and we are all the poorer for it.

Given my stage of life and my client mix, it is prudent for me to stick with my S&P 500 focus, but the companies in the S&P 500 index do not exist in a vacuum. The more the economy grows, the more the S&P 500 companies will grow. To paraphrase Ronald Reagan on a different subject: “Congress! Tear down those growth inhibiting regs!”

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