Commentary: Is the 'incredible shrinking universe of stocks' a bad thing?

In August, Mavis Wanczyk, a 53-year-old from Chicopee, Mass., cashed in her $2 Powerball ticket for a cool $758.7 million, the second-largest lottery payout in U.S. history. Wouldn't it be nice to win? Wouldn't it be nice to be like Ms. Wanczyk, who told her employer she would not be coming to work, not now and not ever?

What about a jackpot of more than $473 billion? That was the mid-2017 market capitalization of Amazon.com Inc., a company that went public with a valuation of only $438 million. Wouldn't it be nice to buy the next Amazon?

One problem, as noted in the Wall Street Journal, is "there are fewer Amazons than there used to be." The financial press has featured numerous articles this year that highlight what Credit Suisse has dubbed"The Incredible Shrinking Universe of Stocks." The number of listed firms has fallen by more than 51% since reaching a peak in 1997, the year of Amazon's debut. This decline has come largely from a drop in younger, more speculative, smaller firms, often exploiting new and emerging technology: a description that fits the nascent Amazon to a T. Meanwhile, older firms, those listed for 10 years or more, have declined by much less. There are 18% fewer of these mature firms now than at Amazon's debut.

Many explanations for this decline have been put forward.

Private markets now provide equity capital in larger quantities and to more mature firms, delaying the need for public equity markets, sometimes indefinitely. Moreover, emerging firms are often less capital intensive, so there is less demand meeting an increased supply of private capital.

Some pundits point to greater scrutiny of public firms by securities regulators, through the Sarbanes-Oxley and Dodd-Frank acts, and by activist investors pushing a short-term agenda. Ironically, other pundits point to lesser scrutiny of public firms, by antitrust regulators that no longer block horizontal mergers as vigilantly.

Billion-dollar ideas like Instagram, WhatsApp and Oculus Rift have reached the public markets indirectly, each having been acquired by Google or Facebook.

Finally, investors themselves mighty be to blame. Larger institutional investors who now dominate the market require a higher level of capitalization and trading volume to pique their interest.

For all of these reasons — and maybe more — there are fewer stocks listed on U.S. exchanges now than two decades ago. Is this an unfortunate development for investors who are now deprived access to the next Amazon? The common refrain in the press is yes. Steven Davidoff's prediction in the Los Angeles Times is particularly stark: "A tragedy of the new normal is that the public equity markets are fast becoming a suckers' game. Small investors never see the better investment opportunities ... As a result, our markets are no longer democratic, they are elitist ... This, in turn, will exacerbate the increasingly acute problem of economic inequality that already is chipping away at the fabric of American society."

Is this true? Would public market investors as a group have been worse off without immediate access to the initial public offerings of 1997? The surprising answer is no. This is for the simple reason that investors cannot collectively pick the Amazon winner from the haystack of losing alternatives. To illustrate this, I computed the returns to a portfolio of U.S. public firms that excludes any firm that has been listed for 10 years or less. Essentially, we consider a parallel universe where, long before the recent decline in listings, investors were unable to buy an IPO until its 10th birthday. A dollar invested this way, starting 35 years ago in 1982, would have grown to $39.33 by the end of 2016. A dollar invested in the whole universe of listed stocks would have grown by $3.49 less, to $35.84, and it would have been a slightly bumpier ride. The difference is small, because firms less than 10 years old average only 16% of total market value, but the young firms that grew to only $22.97, not the mature ones, were the suckers' game.

Despite the appeal of the Powerball jackpot, most educated readers will choose not to buy a ticket; the slim odds of winning have been drilled into us. The expected after-tax payoff from a $2 ticket is barely 80 cents. Powerball preys on the human psychology of the uninitiated, destroying the wealth of the vast majority of those who play habitually.

The odds of finding the next Amazon are not as easy to compute. Even educated investors can be lured into paying high prices for speculative IPOs and other risky stocks in the hope of a lottery-like reward. In my research on the risk anomaly published in the Financial Analyst Journal with Brendan Bradley, Ryan Taliaferro and Jeffrey Wurgler, we explain the superior performance of the lowest risk, most boring, stocks to a combination of investor psychology and constraints on professional money managers.

There might be legitimate rationales to sponsor a state lottery, but increasing the welfare of regular participants is probably not on the list. And, no one would argue state lotteries are a good investment simply by pointing to the winner of yesterday's jackpot. Likewise, there might be numerous reasons to wish for a stronger IPO market, but — counter to conventional wisdom — increasing the wealth of common stock investors is not among those. Rather, the shrinking universe of stocks might well serve to protect investors from their own worst instincts.

Malcolm Baker is director, research, at Acadian Asset Management, Boston, and the Robert G. Kirby Professor of Business Administration at Harvard Business School. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.