“Next the psychiatrist treated the optimist. Trying to dampen his out look, the psychiatrist took him to a room piled to the ceiling with horse manure. But instead of wrinkling his nose in disgust, the optimist emitted just the yelp of delight the psychiatrist had been hoping to hear from his brother, the pessimist. Then he clambered to the top of the pile, dropped to his knees, and began gleefully digging out scoop after scoop with his bare hands. ‘What do you think you’re doing?’ the psychiatrist asked, just as baffled by the optimist as he had been by the pessimist. ‘With all this manure,’ the little boy replied, beaming, ‘there must be a pony in here somewhere!’”
– excerpted from How Ronald Reagan Changed My Life, by Peter Robinson
Jason Zweig is a well-known finance columnist for The Wall Street Journal and also the editor of the revised edition of Benjamin Graham’s The Intelligent Investor (HarperCollins, 2003), the classic text that Warren Buffett has described as “by far the best book about investing ever written”.
Mr. Zweig recently published an article in The Wall Street Journal that captures one important aspect of the active versus passive debate. As the number of publicly traded companies shrinks through consolidation, acquisitions and mergers, there are fewer undiscovered gems, especially for value investors like Mr. Zweig:
In less than two decades, more than half of all publicly traded companies have disappeared. There were 7,355 U.S. stocks in November 1997, according to the Center for Research in Security Prices at the University of Chicago’s Booth School of Business. Nowadays, there are fewer than 3,600.A close look at the data helps explain why stock pickers have been underperforming. And the shrinking number of companies should make all investors more skeptical about the market-beating claims of recently trendy strategies.
In 1999 we started CapitalWorks with an investment fund targeting unloved and misunderstood microcap public companies. Not only were many of these old economy companies out of favor due to the dot-com boom, but they were also extremely hard to research. The consolidation of regional securities firms into much larger broker dealers with sophisticated research departments left many perfectly great industrial and service businesses without any trading sponsorship or investment research simply because they were too small. Geography also was important because many of these microcap orphans were headquartered in the fly over zone. As a consequence there were hundreds of hidden gems waiting to be discovered with hard work of fundamental research and management meetings.
That opportunity space disappeared with the dot-com bust and the subsequent consolidation of survivors. On top of that trend, going public became a rare event as liquidity in the private markets became possible for the first time. Now there is so much less red tape and so much more liquidity that exciting new companies are finding private market ways to support growth and still monetize their investment:
“Back in November 1997, there were more than 2,500 small stocks and nearly 4,000 “microcap” stocks, according to the Center for Research in Security Prices. At the end of 2016, fewer than 1,200 small and just under 1,900 microcap stocks were left.
Most of those companies melted away between 2000 and 2012, but the numbers show no signs of recovering.
Several factors explain the shrinking number of stocks, analysts say, including the regulatory red tape that discourages smaller companies from going and staying public; the flood of venture-capital funding that enables young companies to stay private longer; and the rise of private-equity funds, whose buyouts take shares off the public market.”
Rise Of Private Equity
It is not surprising that the rise of the private equity asset class corresponds almost perfectly with the decline of the micro cap public asset class. The private equity model allowed many management teams to monetize their private investment and still have control of the company they founded. Many management teams also have serial reinvestment and exit cycles side by side with equity sponsors for whom they are owner-managers- two or three bites of the apple. The private equity model became a better petri dish for growth companies than public markets over-regulated by Sarbanes Oxley and Dodd Frank.
Stress Testing Index Funds
It is interesting that the debate today is centered on whether active managers can outperform passive products like ETFs. Everyone is looking at the costs of active management rather than asking about the risks inherent in a collective product like an ETF. We simply don’t know how a product which trades directly but depends on unaffiliated third parties to stabilize its portfolio price will perform in a market meltdown. In a recent interview of retired value investor Bob Rodriguez by Robert Huebscher writing for Advisors Perspectives on June 27, 2017; I was shocked to learn how concentrated the passive products really are, and, in the opinion of a really smart retired guy, may be much riskier than they seem:
Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks. When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.
While I have written about ETFs and how Dodd Frank circuit breakers unintentionally caused many ETFs to hemorrhage in July, 2010, I have not found anything written about stress testing the ETF model. I know one thing for sure. The owner or decision maker on ETF products is probably the weakest hand at the table and the one most likely to fold at exactly the wrong time. This gives credence to Bob Rodriguez question about who is going to buy when the weak hands are all folding at the same moment on their ETF investments. The institutional arbitrage feature of an ETF is meant to follow, not lead, valuation anomalies so it is hard to predict what help, if any, will come from the arbs if ETF trading prices plummet due to a disorderly market. One might speculate that the arbs will short the market basket of securities if they think the weak hand capitulation will influence the whole market.