Smaller companies are staying private for longer, with a sizeable decline in IPOs over the last two decades. So what are the implications for investors of shrinking markets for micro-caps? LARRY SWEDROE has been examining the latest evidence.
There is an interesting July 2020 paper by Robert Blecher, Private Inequity: Private Markets and the Death of the Micro-Cap Stock. Blecher begins by noting: “Public equities have halved in count [from about 8,000 to about 4,000] in the U.S. between the mid-1990s and today, with a paucity of small stocks [micro-caps with capitalisations below $250 million] limiting access to high-growth opportunities for common investors.”
Blecher adds: “While the public markets have contracted, an inverse expansion has been ongoing over the past half-century in the private markets… In private equity, for example, net asset value grew 7.5x between 2002 and 2019, nearly doubling the growth multiple seen in the public markets over the same period.” (Regarding the use of $250 million as the cutoff, it is important to note that in 1995 the S&P 500 was about 500, while today it is almost seven times that.)
The tremendous increase in private equity availability has allowed companies to remain private longer, taking down second, third and fourth rounds of financing. Blecher noted that “‘seed extensions’ have grown at an average yearly rate of 41.9% since 2011.” I would add that the decline in the number of listed companies coincides with passage of the Sarbanes-Oxley Act of 2002, which significantly increased the fixed costs of being a public company, increasing the hurdles to going public.
Blecher’s database included all stocks listed on U.S. exchanges from 1996-2018. Following is a summary of his findings:
- Micro-cap stocks represented roughly 50 percent or more of the total listed equities in the stock market each year from 1985-1998. Following this period, micro-caps went from 3,979 stocks in 1998 to 1,664 stocks in 2018 (a drop of 58 percent), while other classes of stocks went from 3,132 stocks in 1998 to 2,472 stocks in 2018 (a drop of 21 percent). (Again, it is important to consider the difference between a $250 million dollar company at the start of the period and a $250 million dollar company today.)
- There has been a sizeable decline in IPO activity over the past 20 years.
- The decrease in listed equities is most likely attributable to a lack of new entrants via IPOs rather than to increased delisting activity via mergers and acquisitions (M&A), liquidations and involuntary delisting —M&A activity accounted for over 60 percent of delisting activity every year from 2010 on, while liquidations never exceeded 4.5 percent of delisting events from 1997 to 2018.
- While micro-caps historically accounted for an overwhelming majority of delisting events, their share of delistings has actually declined (except during the 2008 financial crisis).
- The decline in the number of publicly listed equities is driven by micro-cap stocks, which once drove initial public offering volume — medium and large IPOs lack a clear pattern in terms of both count and total amount raised.
What are the implications of the findings of a shrinking market for micro-cap companies?
Implications for investors of shrinking markets
To understand the implications of shrinking markets, I examined the historical returns to stocks in the CRSP (Center for Research in Security Prices at the University of Chicago) in deciles 6-8 and decile 10 (the smallest stocks). Note that small stocks are typically defined as those in deciles 6-10.
Over the full period January 1926 through September 2020, stocks in decile 10 returned an annualized 12.7 percent, while those in deciles 6-8 returned 11.3 percent, a difference of 1.4 percentage points per year. The return to decile 9 was 11.3 percent. I also examined the more recent period 2010 through September 2020. The difference in returns between the smallest decile and deciles 6-8 widened to an annualized 1.8 (13.3 versus 11.5) percentage points. The return to decile 9 was 11.6 percent. In other words, the micro-cap premium became slightly stronger.
What conclusions can we draw from the data? First, it’s not the drop in the number of stocks that matters; the reduction in publicly available micro-cap stocks likely means that more of the return to the highest returning companies is ending up in private hands. However, the other side of the coin is that the growing demand from private equity should also reduce the premium they earn from micro-caps.
Second, it seems likely the best performers in the micro-cap arena are the ones able to stay private longer, getting the funding they need from private equity, while the “lottery-like” companies are more likely to go public. The end result might be a reduced differential in the performance of small versus large companies.
However, as noted above, over the last ten years the difference in returns between micro-caps and the other small-cap stocks actually widened — they still provided higher returns.
With that said, in today’s environment of an abundance of private equity capital, it does seem likely that the higher quality smaller companies will stay private longer. Thus, the importance of investing in “quality” small companies and avoiding those “lottery-like” small stocks may be more important than ever.
In looking at the data on private equity, its impact on public capital markets is not as clear as some might believe. Thanks to data from Dimensional, while the amount of assets under management in private equity has increased from about $600 billion at the end of 2000 to about $4 trillion in 2019, private equity as a percent of the global equity market has remained between about 5-7 percent over the last 13 years. And while the median age of a company going through an IPO fell from a high of about 15 years in 2002 to about 10 today, it was also at about 10 in 1992. And finally, about 90 percent of IPOs today are small-cap stocks, about the same percentage it has been over the last 30 years.
Important Disclosure: The analysis contained in this article is for informational and educational purposes only and should not be construed as specific investment, accounting, tax, or legal advice. Investing involves risk, no strategy assures success. The analysis is based upon third party information, which are deemed to be reliable, but its accuracy cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®. R-20-1370
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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