Foreign Stock Offerings and Corporate Buybacks: Continued
The Supply of Equities
The Importance Of Foreign Issuers
The figures also show the importance of foreign issuers in satisfying U.S. demand for equities.
When foreign markets collapsed in Latin America and Asia during the 1980s and 1990s, the impact on retirement plans of Americans was greater than sometimes represented.
It was not so much the direct effect of the profits of foreign companies on the portfolios of retirees, but rather the leverage represented by foreign issuers in a market distorted by massive stock buybacks of domestic companies.
If instead of reducing the supply of equities, domestic issuers had tried to find profitable uses for two trillion dollars in new money coming through institutional investors, the price of equities would have been far lower, yields to investors higher, and the impact of foreign issuers in the market much reduced.
The Investment Stockpile
For purposes of flow of funds analysis, investment is the acquisition of private rights to income originating from capital.
The supply-side of the investment stockpile is a function of aggregate investment income.
There can be no free supply of investments in a communist society because income from capital flows to the government.
In communist countries, with some exceptions, there is only one investor-owner, the government, and all citizens are government employees.
In capitalist regimes, there are four basic kinds of investment income:
- profits of publicly held corporations;
- profits of privately-held businesses;
- rental income from real estate; and
- interest income.
The main source of non-investment income is employment compensation, including wages of state and private employees and their related pension benefits.
Most of the capital that produces investment income comes from the reinvestment of profit from earlier investments.
The national income of a country is made up of employee compensation plus investment income.
Most of the capital that produces investment income comes from the reinvestment of profit from earlier investments.
When profits of a specific project are not sufficient, additional funds must be solicited from other investors.
These additional funds originate from unspent dividends, interest, or rents that belong to these other investors, or from income that employees have saved from their salaries, wages, or pensions.
Creation Of Investment Income
The important driving force in a capitalist economy is the proclivity of certain citizens – entrepreneurial capitalists – to create investment income.
Their motivation may be solely monetary, or it may be based on other things, such as a desire to produce goods or services for society, using profits to reward those that provide the necessary capital.
Many are pushed into capitalist entrepreneurship simply because the alternatives are less attractive.
In other words, a man may build a steel mill to earn money or to produce steel – or both.
Capitalist and entrepreneurial motivation is complex and not fully understood.
Altruistic, patriotic, religious, self-fulfillment, and sundry emotions may be more relevant than the drive to maximize wealth.
Many are pushed into capitalist entrepreneurship simply because the alternatives are less attractive.
Equities are only part of the supply of investment opportunities.
The next graph shows how the availability of investment income has varied in the United States from 1929 to 2002, broken into four categories:
- net interest,
- personal rental income,
- proprietors' income, and
- corporate profits before tax.
The graph shows that, in relative terms, corporate profits have steadily declined since the 1950s, while rentier income (net interest and rents) has increased.
Dwindling Equity Supplies
Even if public companies would abandon the practice of repurchasing shares, using dividends as the preferred way to distribute cash to investors, there may be other causes for a shortage of equities.
New management techniques may make capital more productive.
The market does not automatically transmute capital 'saved' into new securities.
Financial efficiency may result in less need to issue stock.
Better methods may lead to less demand for equity on the part of issuers, but the market does not automatically transmute capital 'saved' into new securities for investors.
Savers do not necessarily have readily available the kind of securities they need for a safe retirement portfolio.
The supply of investments may be slowly leached away through productivity improvements, while savers are unaware that this is happening.
Supply Seems To Meet Demand
When investors continue to buy stock, as supply dwindles, market capitalization – i.e., market size measured by price – automatically expands, seeming to meet demand.
This inflation of apparent supply disguises the erosion of intrinsic value and the scarcity of equity.
In bond markets, a shortage of securities is plain to see.
In markets for securitized debt, emphasis is on yields and credit ratings.
In bond markets, a shortage of investment-grade securities is plain to see.
The way that debt securities are quoted conveys the message.
In Japan, during the 1990s, an expanding elderly population sought investment-grade fixed-income securities while operational efficiencies were 'hollowing out' the economy. The market could not meet demand for prudent investments, forcing interest rates to zero.
Interest rates fall in recessions because the supply of fixed income securities shrinks relative to demand.
Capital Gains Mask A Shortage
In recent decades, U.S. equity investors have sought capital gains, rather than dividends.
Whereas bond interest rates may fall to zero, there is no ceiling on stock prices.
A dearth of equities may pass unnoticed if all eyes are on market appreciation.
From 1980 to 2000, price-earnings ratios tripled, but few perceived this as a sign of a lack of equities.
Equity markets may be driven by Lesser Fools, gambling on the volatile opinions of others.
Economists hope that an Invisible Hand will redirect surplus capital to new, productive uses, assuring equilibrium between investment supply and demand and continued economic progress.
Some even presume that capital will be allocated rationally, on the basis of cash returns from the enterprise.
In fact, equity markets may sometimes be driven by Lesser Fools, gambling on the volatile opinions of others, rather than on assurances of cash yields from issuers.
Other Vehicles Than Stocks
Even if 'saved' capital were efficiently redeployed, it does not follow that this allocation will be in the form of tradable equities.
Capital has many configurations, including interests in sole proprietorships, partnerships, real estate properties, and tiny corporations – none of which are traded on the stock market.
It is a fallacy to assume that good stocks will always be there to meet the needs of savers.
American investors have come to believe that the best way to save for retirement is to purchase a diversified portfolio of listed equities, with some holdings in bonds.
However, the supply of such securities is constrained by law, market mechanics, government policy, and the general state of the economy.
The fallacy in the Common Stock Legend is the assumption that a supply of good stocks will always be there to meet the needs of savers.
Prices may rise, lulling the crowd with unrealized paper profits, while masking an underlying erosion of investment merit.
Investment Policy: A Political Loser
The SEC, Congress, and the Federal Reserve are not concerned about assuring a supply of good investments for savers.
Guaranteeing the creation of investment securities is not even on the policy agenda.
Creation of investment securities is not even on the policy agenda.
Since the trauma of the Great Depression, the spotlight has been on employment – the immediate and prime concern of almost all voters.
Investment policy is a political loser, associated with a tiny group of rich people.
Ninety-eight percent of Americans are employed, or work alone without employees, or are dependent on the salaries or pensions of others.
Popular prejudice against capital and business owners runs deep and politicians understand this.
Impediments To Equity Supply
Institutionalized and cultural impediments hold back the supply of investment securities:
Securities Laws. Only securities registered with the Securities and Exchange Commission may be sold to the American public. This bars most securities traded in foreign markets.
A foreign broker cannot promote unregistered offshore opportunities to Americans, without breaking the law.
Securities laws favor large, domestic companies.
Initial and on-going costs of registration with the SEC are extremely high.
PriceWaterhouseCoopers has estimated that the cost of a one-hundred million dollar public offering in the U.S. would range from $8.4 to $8.8 million dollars. Of this amount, a minimum of $600,000 goes for legal fees, $400,000 for auditors, and $150,000 for printing.
These fees do not decrease proportionately with the size of the issue. However, very small issues offered to a limited number of people are exempt from some aspects of registration.
Almost all U.S. enterprises and foreign issuers are discouraged from offering stocks to the American public.
During the wildest years of the Great Bubble, 1996-1999, only 620 initial public offerings were registered with the SEC each year, on the average.
This means that, in the best of times, only one in fifty-thousand American businesses will go public.
In the best of times only 1 in 50,000 businesses will go public in the U.S.
Although restrictions may appear to protect investors, the effect may be the opposite. A lack of equities may drive prices beyond limits of prudence, while the SEC fails to warn investors of declining investment merit.
The SEC encourages companies to reduce the supply of equities by granting exemption from insider trading and stock manipulation during the buyback process.
Securities laws grant exemptions to issuers of non-equity, illiquid securities.
Short-term commercial paper is exempt from registration and much of the 'securitization' through asset-backed securities results in a reduction in the supply of tradable equities for ordinary investors.
Exemptions for large issues are available for securities sold through private placement to a limited number of 'sophisticated' investors. Hedge funds are a case in point.
Listing Rules. Investors prefer securities that are traded on organized exchanges.
In addition to barriers imposed by securities regulators, the exchanges enact their own rules and fees.
The New York Stock Exchange (NYSE) seeks large, profitable companies that are market-leaders.
In addition to barriers imposed by securities regulators, the exchanges enact their own rules and fees.
The purpose of a stock exchange is to provide liquidity.
This cannot be achieved unless companies are of a certain size, of investment merit, and with a sufficiently wide distribution of shareholders.
NASDAQ, the NYSE, and the AMEX compete for the few corporations that have the ownership distribution, size, and profitability essential to develop active trading.
The NYSE prohibits non-voting common shares and imposes costly rules for corporate governance – measures that discourage private, family-owned companies from listing.
Open-end Mutual Funds. Americans have come to prefer to invest collectively, through open-ended, equity mutual funds.
Since these funds promise to redeem shares on demand, at net asset value, they must restrict their portfolios to actively-traded stocks of large corporations.
Liquidity is a prime concern; the bigger the fund, the greater the need for shares of large, widely-held companies.
There is a limited supply of such securities.
Mutual funds need for liquidity further reduces the supply of acceptable securities.
From the point of view of investment managers, companies are considered to be extremely small ('micro-caps'), when market capitalization is less than four hundred million dollars.
Less than one-half-of-one-percent of American businesses are larger than a 'micro-cap' company.
An entrepreneur with a profitable company, who might consider raising money by selling stocks if he could keep control of the business, would have to own stock worth more than one hundred million dollars to get attention, even from managers of 'small-cap' funds.
During 1997-1999, mutual funds applied an incremental $149 billion each year in stocks; however, new equity issues averaged only $55 billion a year.
Even without buybacks, there would have been a shortage.
Tax Laws. The government favors debt financing over equity.
The rules allow interest to be deducted from income for tax purposes, with no similar benefit for equity profits.
This increases the cost of equity relative to debt and restrains the issuance of equity securities.
Tax laws favor buybacks and real estate investments, neither of which contributes to the supply of equities.
Deindustrialization. Excessive regulation and tax disincentives have led to the gradual decline of industry in the United States.
Businesses in the service sector, relative to industry, require less capital.
Smaller service enterprises are less likely than industrial concerns to list securities on the exchanges.
Therefore, failure to halt deindustrialization has contributed to the shortage of equities.
Globalization. The American government has adopted policies that, intentionally or not, encourage business to go abroad.
The mountains of central and northern Mexico are dotted with factories producing goods that once were manufactured in the United States.
Much of the capital supporting these businesses is held by Mexican interests, financed by funds raised on the Mexican market.
The accumulated impact of globalization in the United States, like the 'hollowing out' of Japan, has been a reduction in the supply of tradable securities.
Attacks on Capitalism. American political history is replete with examples of the populist mob lashing out against capitalists.
The Democratic party gains its strength by decrying the people that the nation depends on for jobs and progress.
Political opportunists in the SEC delight in destroying successful entrepreneurs like Martha Stewart for imaginary offenses and invented crimes.
Demagogues, like Franklin Roosevelt, rant against 'economic royalists', whipping the masses with envy and hate.
Political opportunists in the SEC delight in destroying successful entrepreneurs like Martha Stewart for imaginary offenses and invented crimes, although their self-serving assaults may wipe out the savings of tens of thousands small investors.
For generations, left-wing intellectuals, like Upton Sinclair and Sinclair Lewis, have sneeringly painted distorted caricatures of business leaders, showing them, at one extreme, as proto-fascist enemies of the people, capable of selling spoiled food to the poor for profit, and at the other extreme, as shallow Babbitts – conforming, church-going boosters in unsophisticated local communities – hypocritical fools not worthy of public esteem.
In such a social environment, it is not surprising that only a tiny fraction of American society can actually be classified as capitalists.
The ninety-eight percent of the American people that go through life working for others or self-employed without hired help, contribute nothing to the supply of equities that is needed to support the Common Stock Legend.
The acolytes of the Efficient Market Hypothesis and Wall Street stockbrokers may deny the shortage of equities, but declining dividend yields and rising price earnings ratios, in relation to long-term historical averages, provide evidence that the crisis is real.
