Olly Ludwig:
Over the past 20 years, the number of public companies in the United States has declined. A research paper from Vanguard unpacks what some might find to be a surprising, nearly 50 percent drop in the number of U.S. public companies. Is this something investors should worry about?

With us today we have one of the authors of that paper—which is called What’s behind the falling number of public companies?—to discuss this development in U.S. public markets.

Welcome to Vanguard’s Investment Commentary Podcast series. I’m Olly Ludwig. In this month’s episode, which we’re taping on December 14, 2017, we’re going to look at this decline in the number of companies—from about 7,000 in the mid-1990s to about 3,800 today—and examine how it may be affecting investment markets and investors.

Jim Rowley, the head of active/passive portfolio research with Vanguard Investment Strategy Group, is here to help clarify what’s going on and to help investors and advisors think about this clearly.

Jim, thanks for joining us today.

Jim Rowley: Thanks, Olly, great to be here.

Olly Ludwig: I’m looking at this number—a 50 percent drop, 7,000 to 3,800—that’s half the companies gone in 21 years! Why?

Jim Rowley: I can say it’s maybe a two-step answer to that. One is focusing on what is happening and not necessarily why. So the research here is really focused on what is going on. We talk a lot about why we don’t think it actually matters for investors at the end of the day. Despite that headline number, when we look at the characteristic makeup of U.S. equity markets, according to things such as market capitalization, we really don’t think there’s much of any change for investors.

Olly Ludwig: Well, I’m inclined to think—I’m going back to the headline number—this must be terrible for investors! But you’re saying it’s not bad for investors? Is that correct?

Jim Rowley: Correct. One of the first things we looked into was, the blame seems to be placed on—well, there’s a falling number of IPOs going on. And we thought: Okay, well, let’s take a look at that.

Two trends jumped out to us. Number one was: Let’s look at the IPOs themselves— companies that are being added to the number of public companies. We split the group into larger-sized IPOs and smaller-sized IPOs— larger being those IPOs that have gross proceeds of over 100 million dollars. The number of those types of IPOs, it’s relatively unchanged. There’s a steady trend.

The change that’s happened is the IPOs of companies that have gross proceeds less than 100 million dollars, meaning the really smallest of the small type of companies—micro-cap stocks, those that are not necessarily investable companies.

The other trend we noticed about IPOs is companies that we call “phantom” companies. What we mean by that, there are companies that instead of going public by themselves, they’re acquired by another public company. And, if we go back to measuring the number of public companies, well, clearly, that’s not a “plus one,” because that company didn’t go public. But its economic value, its market capitalization, was assumed by a current public company. So even though it’s not an extra public company, its health, its economic value, its market capitalization, has been captured by the market, it’s just part of another currently public company.

Olly Ludwig: So you’re suggesting that by emphasizing the number of companies, we’re looking at the wrong metric. If we shift gears and begin to look at the entire phenomenon through the lens of market capitalization, is it a nonstory?

Jim Rowley: It’s very much a nonstory when you shift your viewpoint from the number of companies to their market-cap proportionality. What I mean by that is, the paper shows graphics about the number of large-cap, the number of mid-cap, the number of small-cap, and the number of micro-cap companies in U.S. markets. And, clearly, the trend that it shows is the falling number is attributable almost all to a falling number of micro-cap companies. But when you pivot your viewpoint to “but what’s their market-cap proportionality?”—or what’s the impact of viewing those labels not by number but by market cap?—you see that micro-cap companies have, consistently, I might add, accounted for about 1.5 percent of market capitalization in the U.S.

Olly Ludwig: Tempest in a teapot then, in some sense. Let’s talk about the portion of the market that is “steady as she goes”—the larger companies, more than 100 million [dollars] in the IPO. Speak to that a little bit in terms of how that is doing well—a solid trend of steadiness, if not growth, right?

Jim Rowley: For investors, the phrase that we would use is investable markets. And we can apply this discussion, or this concept, to both index funds as well as active funds. If you think about index funds, index funds are typically tracking indexes that are reflective of the broad investable market, or some subset of the investable market—meaning large-, mid-, and small-cap companies that have some minimum amount of size and trading and liquidity requirements that make them investable to the marketplace. And, whether or not you’re an active manager or an index fund, you tend to be engaged in securities in the investable market.

And when we look at those types of companies, the proportion on a market-cap basis of large-caps to mid-caps to small-caps—again, the investable market what investors actually invest in—those proportions? Largely unchanged.

Olly Ludwig: So you’re saying, in some sense, that micro-caps aren’t terribly investable to begin with. And, as far as that goes—again, to reaffirm what I think you just said—the investability of markets, in a general sense, [is] pretty much untouched by this interesting trend that we’re talking about today. Is that fair? And if so, can you develop that just a bit more for me now?

Jim Rowley: I can, and just maybe the way to reiterate that is when you’re thinking about you’re an investor and where you are capturing exposure to U.S. markets on a market-cap basis. You’re getting it from the large-, mid-, and small-cap universe—that’s where the market capitalization of the market sits, with those categories.

When you pivot and you look to micro-cap stocks, they’re just such a small component of the market capitalization of markets; we might deem them to be uninvestable. Just from a magnitude perspective, they just don’t account for that much of the total market.

Olly Ludwig: So we can say what we always say at Vanguard, which is that we want our clients to be fully diversified. In view of this trend, the ability of investors in the United States to be fully diversified is untouched, uncompromised, totally intact. Is that what you’re telling us?

Jim Rowley: We really don’t think you should be measuring the health of the market simply by the number of these companies. But, as an investor, it’s more important to think about the market-capitalization makeup, the proportionality of those segments to each other. And maybe, to take it a step further, the other thing we wanted to check on was: Well, what about the concentration of the markets? Large to mid to small, the proportions are the same against each other, but are there companies in any of those categories that make the market somehow more concentrated? We borrowed a couple [of] measurements from industrial economics that tried to take a look at how concentrated the U.S. equity market is, and we find no change in concentration either.

Olly Ludwig: So if you’ll allow me to pester you just a little bit on this micro-cap question, is it fair to say that the decline in smaller companies means that investors don’t have as much access to the smaller side of the capitalization spectrum as they have had historically? And we know what the research says about smaller-cap companies, maybe higher standard deviation in a portfolio, but on the other hand, the opportunity for some outsized return, potentially. Is there a compromise here that’s coming into focus in connection with these data?

Jim Rowley: I think maybe instead of a compromise, it’s just having the discussion about what it means to invest in U.S. equity markets. If investors are looking at mid- or smaller-cap companies and they’re thinking: “I don’t know if I want to invest in them; they can be more volatile than large-cap companies.” The view from Vanguard is going to be: “They’re part of the U.S. equity market.” To implement an asset allocation with just large-cap equities, for example, look, would we say that that’s the majority of market capitalization? Sure. But it’s still not the total U.S. equity market. Even those mid- and small-cap companies, they are part of the U.S. equity market. So when we’re looking to get exposure to U.S. equities, they’re all part of that family.

Olly Ludwig: On that note, Jim, I want to thank you for sharing your thoughts and your insights and for joining us here for this Vanguard Investment Commentary Podcast to discuss the paper What’s behind the falling number of public companies?

Jim Rowley: Thank you, Olly. Appreciate it.

Olly Ludwig: To learn more about Vanguard’s thoughts on various financial planning topics, check out our website, and be sure to check back with us each month for more insights into the markets and investing. Also, remember that you can always follow us on Twitter and LinkedIn. Thanks for listening.


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