The shrinking US stockmarket and private equity

John Kimber

The number of available equity investments in the USA continues to fall while valuations continue to soar. Issued shares continue to shrink as mergers, buybacks consolidations, declining IPOs and ETFs squeeze out both institutional and private investors. Measured by the broad market indexes the value of US publicly traded equity is booming as a direct result of supply and demand for equities. We revisit several US funds that are benefitting from concentration for which there is no equivalent Australian fund.

In the USA we are already in a bear market for listed choice, diversity and opportunity that is being captured by private equity, crowd funding and importantly for investors, the handful of lenders and finance groups which support entrepreneurs. Look at any index and it is immediately apparent that most of the returns are being captured by the leading stocks. The best examples are Facebook Amazon Netflix and Google which have left everything else well behind.

US taxation laws continue to favour buybacks. There is no franking of dividends rather preferential rates for capital gains. If the past is any guide a planned reduction in the corporate tax rate to 20 per cent from 36 per cent will result in a wave of buybacks further reducing the supply of available equities which are not being replaced. Under the Bush tax cuts for repatriation the top 15 repatriating corporations increased spending on stock buybacks by 38 percent between 2005 to 2006 according to a Senate study in 2011.

In my own case when I first visited Denver in the 1980’s at about the same time as BHP bought Hamilton Oil and Gas there were dozens of small cap stockbrokers. Today there are maybe one or two.

Small cap brokers have been put out of business by regulations including Sarbanes Oxley, aggressive compliance to force brokers into asset gathering and a realization that private equity has taken over the capital raising process. Public listings are much more expensive, putting them out-of-reach for small firms. Private Equity and Venture Capital have stepped in to fill the void. So a smaller number of small cap listings, plus the popularity of index-based investing, has reduced the need for small-cap specialist brokers to bring small firms to market and subsequently provide coverage.

Some would argue that is probably a good thing and the concentration of investment in a handful of leading stocks has led to stockbrokers being replaced by crowdfunding, private equity groups and lenders to small business who tie lending to equity performance. Outside the USA listings have increased by almost the same ratio that they have declined in the USA. Listings have dropped by about 50 per cent in the USA and risen by about 50 per cent in other developed markets since 1996. American Investors and regulators would argue that the quality of US listings have improved as a result of increased regulation. The ASX and other exchanges would argue that the quality of its listings has not declined. The shrinking phenomenon seems to be unique to the USA nevertheless that Rolls Royce in Double Bay or Toorak is likely to be driven by a private company entrepreneur not by a public company director. The numbers are interesting according to Craig Doidge, G. Andrew Karolyi, René M. Stulz, “The U.S. Listing Gap,” Journal of Financial Economics , March 2017

The number of US public companies is 3671 compared with 7322 in 1996 in spite of a doubling in GDP. The market cap of the 50 per cent of remaining stocks has doubled. The Wilshire 5000 index is 3500 companies, and 5000 in 2005. Individual ownership of stocks has dropped from over 25 per cent to under 20 per cent and by much more since 1976 probably from over 50 per cent when stockbrokers were known as “the customers man” rather than asset gatherers today. Good brokers still exist but they are a dying breed. Hedge funds, buyout funds, index funds and venture capital are dominant in spite of the underperformance of many funds.

IPos last year were 128 and 845 in 1996. The average age of companies going public is 18 years and 12 years in 1996. Airbnb was able to raise $850 million in late stage venture capital funding in 2016 and is still not public.

All the entrepreneurs, without exception, that I meet in the USA are looking for a corporate buyout and not a listing on the Nasdaq. Large corporations have largely handed over innovation to smaller entrepreneurial groups and will take a 30 per cent interest after development and before acquisition. A popular primer is the US television show Shark Tank which is required viewing for entrepreneurs. It is almost impossible for a micro or small cap to get broker coverage nowadays. Stock picking is a lost art with the rise of ETFs. MIFID is likely to accentuate this trend. Companies are likely to go private if they cannot attract analyst coverage.

It is worthwhile remembering that the natural home of private equity is in Silicon Valley which is in the same State (California) as Hollywood and although it is 495 km distant its attitude is right next door to the place where dreams are created without the discipline of a public market listing.

If you think that stockmarket valuations are excessive take a look at the valuations created in Hollywood for the Unicorns. The term Unicorn was created in the financial markets so named because they are extremely rare, with often a dozen classes of stock, insiders and mythical valuations. There are no limits on the conditions Investors can request.

Pitchbook is a great place to follow the Unicorns.

All of this leads to the conclusion that diversification requires exposure to early and late stage venture capital which is out of the reach or skill sets of even some of the largest institutional investors. The unlisted T Rowe Price New Horizons Fund run by Henry Ellenbogen is a good example of a fund that invests in private equity deals. The opportunity is the gap between the common stock valuation and preference stock issued as the company expands. It has outperformed the leading BDCs in our tables below and the indexes.

Listed funds which are equipped to deal with private equity and whose valuations are governed by the markets include familiar names like Blackstone (not Blackrock). The symbol is BX.

Since we wrote about Business Development Companies in July this year the average gain has been less than the markets except for Apollo

Here is the performance table for the leading listed US funds that we follow since we wrote in July.

Apollo APO 8 pct Market Cap $5,677 millioc

The Carlyle Group CG 4 pct Market cap $1,921 million

Blackstone BX minus 8 pct Market Cap $2,100 million

Ares ARCC minus 1 pct Market Cap $1,538 million

Hercules HTGC 1 pct Market Cap $1,148 million

The market measured by the Dow rose 8 pct in the same period.

In the ETF grouping we have been following

Powershares Listed Private Equity PSP minus 2 pct

Van Eck Vect Income BIZD minus 5 PCT

If we take a three year history of performance the picture changes dramatically.

Carlyle minus 24 pct

Area minus 1 pct

Hercules minus 12 pct

Apollo plus 28 pct

Blackstone plus 0 pct

The Dow rose 37 per cent in the same period.

BOTH SETS OF FIGURES COMPARE WITH THE T ROWE PRICE NEW HORIZONS FUND WHICH ADVANCED 54 PCT OVER THREE YEARS AND 7 PER CENT IN THE LAST SIX MONTHS.

Turning to the Exchange Traded Funds the performance over three years has been

PSP plus 11 pct

BIZD minus 11 pct

We are indebted to (VIEW LINK) for the following analysis of PSP

ALTAR

SCORE™

5.6%

RECOMMEN-

DATION

UNDERWEIGHT

2017E 2018E

P/E

RATIO

13.7x

P/SALES

RATIO

1.8x

P/BV

RATIO

1.4x

DIV.

YIELD

4.0%

For many investors the attraction of BDCs are their high yields and exposure to growth which does not come without its risks. However pending changes to the corporate tax rate will have a major impact on all BDCs, depending on their exposure to corporate taxes in the companies in which they have invested.

Apollo is the best performing amongst the largest cap BDCs.

And by the way here are the performance by share price for each of the seven listed US Funds Managers over the last 12 months

T Rowe Price 31 pct

Blackrock 27 pct

Brookfield 22 pct

State Street 19 pct

Blackstone 19 pct

Invesco 12 pct

Ben Franklin 5 pct


John Kimber

Over 30 years in Australia, South Africa, London and the United States John Kimber has worked in investment research, advisory, and corporate finance at Prudential Securities, BT Alex Brown and Ord Minnett. He completed his series seven...

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