In the decades since professors Eugene Fama and Kenneth French published their famous 1992 paper on company size being one of the three sources of equity returns, the edict that small stocks outperform their larger brethren has become conventional wisdom. Total assets in small-cap mutual funds, including target-date and other allocation funds, have grown from $473 billion at the end of 2007 to $779 billion year-to-date in 2016. But the Federal Reserve’s extraordinary experiments with loose monetary policy since the financial crisis and other developments are distorting the market for small caps, market observers say — and the end result is a big reduction in the world of public small companies, new research shows.
From 2006 to 2016, the number of publicly traded small-cap stocks plummeted from 3,726 to 2,666, according to small-cap research firm Furey Research Partners. In the past year, the market lost another 31 small-cap stocks, according to Furey.
Robert D’Alelio, who co-manages Neuberger Berman’s $10.6 billion Genesis Fund, a small-cap value fund, argues that one of the reasons behind the trend is that small companies no longer have to rely on public markets to get the financing they need. He explains that the Fed has kept interest rates low, driving down the cost of capital and changing the fundamental model of financing for small-cap companies.
In the past, entrepreneurs primarily got their initial financing in the private markets — from venture funds, for example — and then planned on eventually going public to get access to global capital markets and big investors such as mutual fund companies and pension funds.
“But when money is loose and people are dying for returns, they fight to get in front of the IPO. Why buy an IPO when you can get a company before it goes public?” asks D’Alelio.
Fidelity Investments, Hartford, T. Rowe Price, Vanguard Group and others are buying stakes in these private companies, rather than wait for them to go public. As a result, there are many private companies that have reached market capitalizations of more than $1 billion — companies that were nicknamed “unicorns,” because they were rarely if ever seen. “If you can grow to $10 billion in size and not have to deal with the hassles of disclosures required by public companies and other burdens, why wouldn’t you?” asks D’Alelio.
In addition to fewer IPOs, many now-public small companies are also increasingly being taken off the market. Private equity firms and strategic buyers have used low rates to buy smaller public companies and take them private, says D’Alelio.
Charles Bobrinskoy, vice chairman and head of the domestic investment team at Ariel Investments, which primarily manages small- and midcap value funds, adds that private equity firms have picked through the field of small companies. Instead of bringing these companies public, as they used to do after a couple of years, they’re selling them to other private equity funds. Private equity also continues to gain influence over small caps as investors increase their allocations to the asset class. “It’s getting tougher to find good undiscovered small-cap stocks,” he says.
D’Alelio says he’s particularly worried about companies he holds being taken private in the current environment. In the past, he says, when one of his holdings was sold to a strategic buyer at a price he thought was unfairly low, he would call three or four portfolio managers who also held the stock and then reach out to the company’s management. But with the rise of small-cap index funds, which buy stocks simply because they are in a benchmark, not because of fundamental research, there are fewer people to call with in-depth knowledge of a public company’s valuation. As a result, small companies get bought up with less market scrutiny.
“There are fewer of us out there — active managers — who would say, ‘That’s crazy; you can’t take this company private at that price,’” D’Alelio says.
The upshot: The number of small public companies is dropping fast, and there are fewer people to protest when they go private.