The US stock market is becoming a dumping ground

A real possibility that the stock market has become a dumping ground for businesses.

A lot of people are worried about the shrinking number of public companies in the US, but quality is an even bigger problem than quantity.

JPMorgan Chase & Co Chief Executive Officer Jamie Dimon lamented in his most recent annual letter to shareholders that there are only 4,300 US stocks, down from 7,300 in 1996. Meanwhile, Dimon noted, the number of private companies backed by private equity has ballooned to 11,200 from 1,900 during the past two decades.

It’s unquestionably harder to be a public company than it used to be. Dimon hit on many of the reasons including increasingly burdensome regulation, intensifying public scrutiny and a growing obsession with short-term financial results. It’s also no longer necessary for many companies. Private equity is awash with cash, making it easier for businesses to raise capital from private sources. So, why go public?

It’s time to consider the real possibility that the stock market has become a dumping ground for businesses too weak to attract capital in private markets. That’s not a good development for investors or the market.

Systemically, this trend is worrisome because private companies, a number of which are as valuable as public ones, bypass many of the disclosure and governance rules the US adopted for public companies after the Great Depression. These are meant to make markets more efficient and transparent — and to help avert a repeat of the devastating stock market crash that sparked the Depression.

The challenge for ordinary investors is more immediate: Most of them are confined to the stock market because financial regulation bars them from investing in private markets. Unfortunately, the quality of small public companies — those similar in market value to the businesses that predominate private markets — has deteriorated significantly.

Look at the Russell 2000 Index, probably the best-known tracker of small public companies. In 1995, the index’s profitability, as measured by return on equity, was 7.8 percent. It has trended lower ever since, and this year, Wall Street analysts expect an ROE closer to 2.4 percent. The same trend is apparent when looking at other measures of profitability, including return on capital or assets.

Other data tell a similar story. In 1963, the ratio of small public companies with the lowest ROE to those with the highest was 1.6, according to numbers compiled by Tuck School of Business Professor Ken French. That ratio remained relatively stable for more than two decades, fluctuating between 1 and 2 through the 1980s. But it began to spike in the 1990s and is now closer to 6.

In other words, for every small public company that is highly profitable, many others are struggling. That’s evident in the Russell 2000. Nearly a third of its companies are expected to lose money this year, and an additional 20 percent are expected to eke out a profit of less than $1 a share.

No surprise, then, that investors prefer big companies to small. The S&P 500 is expected to post an ROE of 18 percent this year, compared with a little more than 2 percent for the Russell 2000. And the S&P 500 is cheaper to boot, trading at 24 times expected earnings for this year, compared with 38 times for the Russell 2000, mainly because the horde of small companies expected to lose money weigh down the index’s earnings.

Looking at those numbers, it’s an easy choice. Large companies usually attract more capital, but investors are pulling money from small companies. Since 2020, they have handed a net $107 billion to large-cap US stock mutual funds and exchange-traded funds while yanking $3 billion from small-cap funds, according to Morningstar.

Look deeper, though, and there are plenty of small companies to like. I sorted Russell 2000 companies by ROE and spotted 235 that are expected to be at least as profitable as the S&P 500 this year. Based on market value, their weighted average ROE is 46 percent, more than double that of the S&P 500. And with a forward P/E ratio of 22 times, they are also about 10 percent cheaper than the S&P 500. Even more enticing is their median P/E ratio of only 13 times, which shows there are some high-quality bargains among them.

That doesn’t mean retail investors have to comb through financial data to find the cheapest and most profitable small public companies — most people don’t have the time or inclination to do that. Nor do they necessarily have to invest in small companies at all.

But for those who want to diversify beyond the biggest companies, or who fear missing out on smaller businesses in private markets, one option is to look for a low-cost ETF that targets small public companies with lower valuations and higher profitability. I’d expect these ETFs to perform at least as well as most private equity funds over time, particularly given the exorbitant fees private funds charge their exclusive investors.

I also expect that the stay-private trend will accelerate — to the stock market’s detriment and to the growing exclusion of retail investors — unless policymakers intervene. They can start by removing the gates that prevent ordinary investors from participating in private markets. They should also require private companies above a certain size or market value to abide by the same rules as public companies, mindful of the burdens that regulations impose on all companies.

In the meantime, investors need to be more discriminating when playing in the small-cap space. The opportunities are worth the effort.

Credit: Bloomberg