Thursday, February 17, 2011

Shareholder capitalism under threat?

Stock markets, one of the bedrocks of modern capitalism, are supposed to ensure efficient allocation of financial resources by both providing a platform for businesses to raise investible funds and an outlet for investors, big and small, to invest their savings. However, there is an increasingly evident trend that questions whether either objective is being met.

On the one hand, businesses, atleast the best-performing ones, are raising an increasing share of their financial needs privately. On the other hand, the sharp market volatility of recent years, coupled with pervasive regulatory failures, mean that equity markets are no longer as safe and attractive an investment option for the small retail investor as earlier.

In an excellent NYT op-ed, Felix Salmon brilliantly captures the "noisy sideshow" that stocks markets have become in the US. He writes about the equity market trends in the US,

"The stock market is becoming increasingly irrelevant — a trend that threatens the core principles of American capitalism. These days a healthy stock market doesn’t mean a healthy economy, as a glance at the high unemployment rate or the low labor-market participation rate will show... What’s good for Wall Street isn’t necessarily good for Main Street... the glory days of publicly traded companies dominating the American business landscape may be over. The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It’s now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink... Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money."

He writes that the shares of innovative listed companies like Google and Apple "are essentially speculative investments for people making a bet on how we’re going to live in the future". Further, attractive technology firms like Facebook and Twitter raise resources privately and are therefore out of bounds common investor public. The insulation from regulatory oversight, investor accountability, and the pressures to match market expectations, mean that companies prefer it that way. His conclusion raises serious concerns,

"Only the biggest and oldest companies are happy being listed on public markets today. As a result, the stock market as a whole increasingly fails to reflect the vibrancy and heterogeneity of the broader economy. To invest in younger, smaller companies, you increasingly need to be a member of the ultra-rich elite."

Stock markets continue to be important sources of raising business capital in countries like India. However, like in the US and other developed markets, derivative operations have assumed an increasing share of equity markets in India.

An examination of the records on capital raised by private firms through private placement and public market offerings throws up interesting results. As can be seen, private placement remains the overwhelmingly major route for private firms to raise fresh capital and the preference is increasing.

Even after deducting the share of private financial institutions share in the private placement market, the figures remain heavily skewed in favor of the private placement route.

Given all this, primary market remains a small investment channel for retail investors. Most retail investor activity is confined to the secondary markets, and as mentioned above, increasingly to the derivative markets.


sai prasad said...

The percentage of money invested in the stock market by private, small investers is not very high in the USA and is even lower in India.

I feel that the issue you have raised stems from the fact that share prices are getting far removed from actual performance and it is getting more and more linked to expectations of future.

Since the information to assess the future is asymmetrical in availability and is of doubtful quality, share prices of companies are disconnected from reality and is getting to be the preserve of a few who can manipulate the information.

I think it is time we take steps to ensure that stock prices reflect todays performance primarily.

gulzar said...

i do not have the exact stats. the percentage of money, as a share of total equity market investments, may be small. but the percentage of Americans investing in share markets and the share of their wealth invested (directly or indirectly) in equity markets is not small. the latter will be high in India too.

equity valuations are primarily decided by the market's expectations of the future performance of the underlying company/business. this is both its strength and weakness. nobody would buy a share if it merely reflects its current price. people buy it in expectation of profiting from its future performance.

the weakness is that such valuations therefore become susceptible to bouts of "irrational exuberance" and deviate hugely from what the fundamentals of the company would reasonably indicate. as you said, the information asymmetry etc adds to the problem of arriving at a reasonable valuation.

how do we mitigate this? better regulation will help, but can only do so much. the fundamental premise of any efficient equity markets is the availability all relevant information, so that the most efficeint price discovery takes place. when the herd metality strikes, information gets ignored or overlooked. so the challenge is to keep having information channels fully open and ensuring that actors respond approapriately to it.