There are not enough public companies

Why the current market mania is driven by a lack of supply.

Mobile computing makes lots of things easier.

Some of this is bad. Much of this is good. 

One of the things made significantly easier by a smartphone is stock trading, which is just the right amount of good and bad. 

Data shows that Robinhood — along with other major online brokers — has seen a surge in activity over the last few months as new investors are drawn to the market. Maybe low prices are enticing new traders, maybe $1,200 stimulus checks did the trick, or perhaps daily fantasy sports players looking for a fix in a world without sports found stocks as a good replacement. 

All of these are true, to an extent. 

But one doesn’t need a grand unified theory of why people started trading this spring to know that it is happening and weird things have happened in markets as a result. And although Barclays argued on Friday that Robinhood is not behind the rally in a research note, that same note acknowledged, “that there are many examples of big stock gains coming along with big increases in Robinhood customer holdings.” 

Airline and travel stocks, for instance, have gone nuts with Robinhood data revealing some of these names were added to tens of thousands of new portfolios as shares climbed. And that’s all the argument about retail’s role in this market is trying to say — this class of investor is now a source of real investment dollars.

Even if I went a step further last week and argued retail might be the smart money in this market, that specific view can be wrong while the role retail plays in the market growing in import remains true. 

And as we continue to see the strange and novel ways the stock market behaves in this environment, what increased retail participation has highlighted is a serious lack of supply in the public equity market. 

We might still be worried about market liquidity

Those who follow markets closely will be well aware of conversations about market liquidity in recent years. There were several months — if not an entire year — during which Matt Levine dedicated a section of his Money Stuff newsletter to “People are worried about stock/bond/currency/private market liquidity” every single day. There was that much to say about illiquidity in markets. And Matt didn’t even say it all. 

And the way retail has risen as a part of the market’s recent narrative is as much a sentiment story as it is a liquidity story. And, yes, new investors looking to turn $50 into $200 are going to view the stock market differently than someone with six- or seven-figures invested trying to build long-term wealth.

The financial industry’s perpetual challenge is turning the trading enthusiast into a long-term customer that remains both active and solvent. Activity and solvency in trading are in direct competition with one another, and the more novice the trader the more quickly solvency is liable to become that customer’s primary constraint. 

But that this new class of investor seems to have so quickly found its way to trends like buying airline stocks on the economic re-opening, buying Nikola stock because it is Tesla’s first name, and buying shares of companies that had filed or were rumored to be filing for bankruptcy protection shows there just aren’t enough public securities available to offer even a modest increase in new participants much else beyond off-the-wall investment opportunities. 

This episode in market history seems to be reaching its apex — or nadir, depending — with news from Hertz that the bankrupt car rental company will raise $1 billion in equity to fund operations. That is, a company with $19 billion in debt will raise $1 billion from investors at the bottom of its capital stack because, as the company’s lawyer told the FT, “New platforms for day traders may be facilitating this...There are forces at work that us non-financial people, that we can only observe.”

An all-time great corporate statement. 

This ridiculous episode, however, couldn’t be a clearer example of how little supply there is for opportunity-starved investors. There is a mismatch right now, and a significant one, between the demand for common stocks and the market’s supply of them. 

And don’t take it from me or Robinhood or Hertz. Just look at the actions of investment bankers and some of the game’s most sophisticated investors. 

Watch what they do, not what they say

In recent weeks, IPO activity has increased.

Reports indicate that Airbnb and Palantir might try to make it to market this year. And the year’s most interesting filing to date came from insurance startup Lemonade this week, with Byrne Hobart characterizing the filing thusly:

It’s a company whose unit economics can work, but are still unproven because of the lag between when policies get sold and when they get upsold. They’ve built a great product for a small market, and they’re promising to go after a huge one, but that’s more of a Series C pitch than an IPO pitch.

[...]

So, why raise now, and why IPO?

My suspicion is that this is yet another marketing channel. Lemonade doesn’t need cash, but they do need attention. IPOs tend to increase name recognition, and the daytrader market is in the middle of a bubble. Lemonade may have concluded that they could IPO any time, but if they’re going to use Robinhood to get a free brand ad in front of 10 million people, they’d better act fast.

And away from traditional IPOs, there’s new enthusiasm for SPACs, or special purpose acquisition companies, which are publicly-traded entities investors dump a bunch of money into now so that later, the SPAC can buy a company and bring it to the public market without all the IPO decorations. 

This is how Virgin Galactic went public, and DraftKings, and Nikola each made it to the public markets. In the future, something sponsored by Bill Ackman will do the same.

Everyone can say and write lots of things about whether the market currently appears adequately supplied or not, but the actions of investors, founders, and their sponsors indicates there is an inefficiency in the public market available for exploitation.

And the inefficiency may be no more complicated than there not being enough stuff for people to invest in. 

Everything is derivative

So while recent market and social dynamics may have primed the pump for the stock market to reveal its lack of supply as a trend to be exploited, for decades we’ve seen the number of companies trading on the public markets shrinking. 

The conditions for this kind of market moment did not just crop up overnight.

Back in 2017, Michael Mauboussin — then of Credit Suisse — explored the shrinking number of public companies in the market and how it changes market dynamics. Fewer public companies, in Mauboussin’s view, makes diversification more challenging because the public market offers you a narrower slice of the investable universe. Companies on the market now are older, more profitable, and more concentrated across sectors. 

“In 1976, an institutional investor who wanted exposure to U.S. equities had only to buy a diversified portfolio of public companies and a venture capital (VC) fund,” Mauboussin writes. “In 2016, that investor would have to buy a diversified portfolio of public companies, a private equity fund, and late-stage as well as early-stage venture capital.”

Filling this gap in the number of securities available to buy and sell is the exchange-traded fund. Mauboussin notes that in 1993, there was 1 U.S. equity ETF. As of 2016, there were more than 650. 

If you Google “how many ETFs are there” right now, you’ll get a number from Statista that is north of 6,900, which presumably covers all asset classes and geographies. 

But there is just about no number — within reasonable tolerances — that someone following markets would deem too high for an estimate of how many ETFs are out there. 

But in introducing the rise of the ETF, Mauboussin describes how bets on horse racing have moved away from traditional bets on win, place, show and towards what are called “exotics,” or derivatives on horse races. 

Steven Crist, a well-known horse racing journalist and handicapper, points out that 90 percent of wagers on horse races in 1976 were based simply on win, place, or show. More than 70 percent of wagers today are known as exotics, which involve wagers on the extended order of finish in a particular race or the winners of consecutive races. For example, a handicapper may wager on which horses will finish 1-2, or 1-2-3. The outcomes from these wagers derive from more complex race results.   

This is the same role, basically, that daily fantasy plays in the broader sports betting universe. And these derivatives are why the value of live sports television rights, even amid a pandemic and financial distress across the sports entertainment industrial complex, are likely to increase over time. One contest can be increasingly chopped up for new betting opportunities that keeps fans interested or draws new punters into the fold. 

And so as the stock market has also increasingly become a meta-market wherein bets on public companies are placed in vehicles that offer investors a claim on an ownership share rather than the share of ownership itself, an opportunity to offer investors actual common stock has once again been created. And it follows that if price discovery for common stocks is driven primarily by the promised proportional claim on a company inside a derivative product, the underlying claim on said company is likely mispriced. 

Things, however, are not that easy. 

Minnows down, sharks up

As the number of public companies has shrunk and the number of ETFs has increased, the nature of investing business has also changed dramatically.

And with this change comes increased, not decreased, pricing efficiency.

Because if fewer would-be PMs are now focused on marketing derivative products based on a formula instead of making true discretionary market bets, the marginal weak hand is being shaken out. Yesterday’s active manager is today’s marketing director. A 2013 paper also from Mauboussin outlined that as the sophistication of investors in the stock market has increased over the last several decades, available alpha has declined. 

Unfortunately, I don’t have a link to the paper, though the paper’s lone chart makes the point quite well.

What we should expect, then, is that if this opportunity for investors offering a supply-starved set of investors new issues is real, the void will be filled quickly. But this doesn’t mean the opportunity isn’t attractive and won’t remain so for some time.  

Whether an IPO, a SPAC, or a direct listing is the best opportunity for a business is the topic for another conversation. But in an industry this competitive, several unrelated players circling the same idea says more about the idea than it does the players. 

Indeed, as we outlined above, there are brand name companies and brand name investors sniffing out the same opportunity.

And the opportunity is simple: issue common equity.

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