Emerging companies are delivering the growth. Investors still won’t pay for it

As the chart above shows, the number of ASX companies over the past three years has decreased by around 200, which represents a decline of about 10%. If you look at the total value, it's increased by roughly 20%.

The largest businesses keep getting larger, while the smaller names are thinning out. Three-quarters of the ASX by value sits in companies worth more than $10 billion, yet 60% of listed companies by number are worth $100 million or less.

So the ASX is shrinking from the bottom up. But what does that mean for investors looking to own those emerging companies that are disappearing from the public market?

"The way we invest has not changed," Chief Investment Officer Sebastian Evans told investors at NAOS's annual roadshow. "But what's very much changed is the markets we operate in as a fund manager."

It isn't just an Australian problem. The US market is also shrinking, "albeit nowhere near as fast as what we are", which Evans reads as a structural issue with how appealing it is to run a listed business.

The IPO drought

Takeovers, administrations and mergers are removing companies faster than IPOs replace them. That leads to a question: "How many people can remember the last quality IPO that's come across their desk?"

Evans says there are two that jump to mind: commercial fitout business FDC (ASX: FDC) and retail piercer SkinKandy (ASX: SK1), which has a market cap of about $200 million.

“Outside of that, and probably outside of resources, there hasn't been too many,” he says.

“You’ve got to ask yourself, why do companies seek to IPO? Generally, companies seek to IPO because they need money, or the founder or the owner needs to sell down and realise some of their investment. Generally, not two reasons to invest in a business that you're an inherently conservative investor.”

On top of this, vendors are usually private equity or founders who know far more than the buyer, being public market investors. A prospectus is mostly backward-looking, creating what Evans calls "an information arbitrage for the seller versus the buyer". Recent floats have also been hit and miss.

"Generally, you're better off waiting to see the trading performance of an IPO as opposed to being the IPO investor," he adds.

An ageing Australian investor base also wants reliable income, which doesn't match the riskier, capital-hungry businesses that tend to list.

Takeovers are picking off the quality

The flip side is a steady stream of bids for businesses like BlueScope (ASX: BSL), Cleanaway (ASX: CWY), Steadfast (ASX: SDF), Reliance Worldwide (ASX: RWC) and Perpetual (ASX: PPT). 

"They're all real cash generating businesses that have been built over a long period of time. You couldn't just replicate a Cleanaway Waste Management business in three years. It would take you decades, if at all."

Bidders, in his view, see more value than equity markets do and many are sophisticated, long-term capital such as Brookfield, not typical five-year private equity.

"They just feel like if they can pay a 33% premium to the last share price, they're probably going to get it." 

MaxiPARTS Ltd (ASX: MXI) is NAOS's own example. It posted a record half yet traded at a record-low share price, then drew a bid from a global private equity firm. Evans puts it down to demand rather than earnings.

"Emerging companies have been going down, not because earnings have been going down, but more the fact that there's just a lack of investor demand."

Passive money and the valuation gap

Evans argues passive investing is distorting prices. ETFs hold close to a quarter of the ASX 200's market capitalisation, roughly 90% of ETF flows go into passive strategies, and the top 20 stocks make up about 60% of the index.

"As a board, ultimately you report not to me, sometimes to a retail investor. You probably report to an ETF provider. It's quite an interesting context," he says.

"Companies today are not pressured to grow earnings like they were a number of years ago because their share registers today are dominated by passive investment strategies. Passive investment strategies don't get marked by how far they outperform. They get marked on just providing an index-like return."

The result is a paradox: "Emerging companies are providing most of the growth, yet people aren't willing to pay for it."

Evans expects sentiment to turn once rates stop rising. "I think people's psychology will change," he says, with investors seeking riskier assets in small and micro caps and share prices re-rating "quite aggressively".