Investors face a shrinking stock supply

Matt Krantz, USA TODAY | USATODAY

Investors have faced plenty of challenges trying to build a healthy stock portfolio. Now, even as the market hits new highs, there is a new hurdle to throw into the mix: the dramatically shrinking list of companies willing to sell shares to the public.

Companies have been gobbled up in mergers or gone private. Some have thrown up their hands in disgust with Wall Street. Others have been involuntarily delisted because their businesses are suffering. Meanwhile, the engine of new stocks, the initial public offering market, remains moribund.

The stock market is shrinking. The number of companies that individual investors can buy shares in is in a breathtaking decline, continuing a fall that's been years in the making but that's accelerated this year with its record-breaking start to takeovers, mergers and buyouts.

"The stock market is going private," says Robert Maltbie of Singular Research. "It keeps self consuming."

The ramifications of this are significant, and the simple reason is the average investor has fewer choices, both broadly and within specific industries, when it comes to picking individual stocks.

While some investors feel Wall Street is a rigged game and stock volatility is upsetting, the ability for an individual investor to buy shares of American companies in the same way as a billionaire is one of the defining characteristics of the U.S.' capitalistic system.

Dell, US Airways, Heinz and OfficeMax are just a few of the iconic American companies that this year announced plans to no longer trade as independent companies.

The numbers tell an even more dramatic story of how many publicly traded companies are vanishing. The Wilshire 5000 index is a market measure of all the U.S.-based firms that have shares that can be traded. For decades, it's been a proxy for the size, breadth and value of the entire stock market.

But even the Wilshire 5000 can't maintain enough companies to reach its namesake number. There now are 3,678 companies in the index, is down by more than a third in a decade and off by nearly half from its level in 2000, says Wilshire Associates.

The number of publicly traded companies always ebbs and flows, but the current number has fallen steadily since at least 2000. At 3,678, the number of companies available for the public to invest in is much closer to the low of 3,069 in February 1971 than to the high of 7,562 in July 1998. Granted, there are thousands of stocks traded on "Pink Sheets" and other lightly or unregulated markets, but the Wilshire 5000 only includes those that trade on an exchange such as the New York Stock Exchange or Nasdaq.

It's not just a blip with the Wilshire 5000. The total number of listed securities trading on the Nasdaq OMX and NYSE Euronext exchanges was 4,916, according to the World Federation of Exchanges. The number of listed securities on these two critical exchanges has fallen every year since 2009 and is down 32% since 2000 and 39% from the recent peak in 1997. Making that more troubling: That number includes listings that aren't companies, such as exchange-traded funds, which have soared in popularity.

Some of the forces winnowing the ranks of publicly traded companies and greatly reducing options for investors include:

• Widening domination of big companies at the expense of smaller firms. Smaller companies are having an increasingly difficult time making money, as a majority of corporate profit is produced by large firms, says Jay Ritter, professor of finance at the University of Florida.

Large companies have developed such an advantage through their massive sales forces and big budgets that they suck up most of the profit to be had, leaving scraps for smaller ones.

More than 80% of large companies, those with $250 million or more in annual sales, have been profitable in the past decade, Ritter says. Compare that with the 50% of small firms that have managed to eke out out profits in that time.

Forces that benefit large companies with global reach continue to escalate, making it harder for small companies to compete, Ritter says. Americans aren't favoring the underdogs of business; the opposite is true. In many industries, Americans are gravitating to the products of behemoths and ignoring the scrappy competitors. Take the lucrative smartphone industry: Apple and Google garner more than 90% of it, leaving little of the market for smaller players such as Nokia, Ritter says. "Increasingly, in many industries, it's a winner-takes-all situation," he says.

• Rampant merger and buyout activity. There's been a steady drumbeat of companies being bought out and merged out. Even during the recession years of 2008 and 2009, 8,778 and 7,415 U.S. companies, respectively were bought, says Dealogic. That's ramped up to 10,108, 10,518 and 12,194 in 2010, 2011 and 2012, respectively.

All this buying activity has directly reduced the value of shares available for investors to buy from $17 trillion to $12 trillion, Maltbie says. Now that companies can borrow so cheaply, they can afford to buy rivals and get instant gains.

With so many companies being bought, individual investors are finding they can't get exposure to some industries as they could before. Years ago, investors who wanted to invest in computer hardware, for instance, had scores of options. Now, there are a few major players such as Apple and Hewlett-Packard. It's the same in the airline industry. Ironically, the stock exchanges themselves have been buyout fodder. NYSE Euronext, parent of the fabled, New York Stock Exchange, was bought by competitor IntercontinentalExchange in late 2012.

• Dead IPO market. The process of companies dropping off the stock market is a natural and long-standing one. Companies burn away in much the same way a forest fire clears out weaker trees, leaving more sunshine and nutrients for the stronger ones.

But for the stock market burn-and-renewal cycle to work, there needs to be a supply of saplings, which, in the case of the stock market, are exciting young companies.

That's not happening. The IPO market remains very weak despite the strength of the stock market. Normally, a strong market for IPOs comes along with a market rally, which is missing this time. Just 128 IPOs were done in all of 2012, slightly better than the already weak 125 that were done in 2011, says Renaissance Capital. That's a far cry from the 486 and 403 companies that went public in 1999 and 2000, respectively.

"During the tech bubble, companies were racing to take any business to market," says Bob Waid of Wilshire. "Now, companies are looking more carefully about going public."

The weakness in the IPO market is a rational response to a change in the economic system, creating a trend that's likely to continue, Ritter says. CEOs of young companies are making the decision to be bought out instead of trying to go public, Ritter says.

It's all about money and how much entrepreneurs can maximize gains. To compete with larger companies, entrepreneurs would have to invest heavily in back-office functions, such as creating a massive sales force and building a marketing department. Rather than going to all that expense, the young company could be sold to a larger one that has all the business plumbing in place. An existing public company can afford to pay more for the small company than an IPO would generate.

"For many companies, selling out is getting more value, as the bigger company can integrate the technology and get higher sales," Ritter says.

• Public distrust of stocks creating relatively low valuations. Exacerbating the situation is that many individual investors, for various reasons, have sworn off stocks, Maltbie says. With fewer public buyers, valuations of many public companies fall, especially relative to what those companies are worth to private investors and other companies.

Investors' distrust of the stock market has been fanned by unfortunate events such as the famous "Flash Crash" of May 2010, when stocks briefly plunged 10% or more in a matter of second for no apparent reason, coupled with the Bernard Madoff scandal of 2009 and the accounting scams of the early 2000s. "People think the stock market is rigged," Maltbie says.

When companies aren't getting fully valued by the stock market, there are plenty of alternatives for businesses to get their full appreciation, especially when debt is so cheap. Companies can sell out to private investors, which can, in turn, buy the company using borrowed money at 4% or less.

The decline in the number of publicly traded companies is indisputable. The ramifications of this major change, though, are less clear.

Some investors wonder what will happen if the number of companies continues to decline. If investors continue to avoid stocks, eventually, U.S. markets could shrivel to the point there is a relatively small group of significant companies to be invested in -- as is the case in Europe, Maltbie says.

There are also concerns about what will happen to the trillions of dollars invested in mutual funds and pension plans that need to go somewhere. If all the nation's pools of money are chasing a dwindling number of stocks with the same pools of dollars, wouldn't that cause the stocks to get overvalued?

That's not likely, says Wilshire's Waid. Along with the declining number of publicly traded stocks has come the rise of private-equity firms, which use borrowed money to buy out companies and take them private. A growing number of large institutional investors are placing money with those firms. Additionally, it's become easier for investors to put their money in overseas companies, he says.

Given the powerful trends in place, Ritter doesn't expect to see the number of publicly traded companies start to rebound soon. As behemoth publicly traded companies get even bigger, though, there are still plenty of shares to go around. "There's not a shortage in public equity," he says. "Instead of investing in 100 different companies with 10 million shares, people can buy 100 shares of a company with a billion shares," he says.