Fear not — equity is far from cancelled

During a speech last week in Zurich, I giggled at the irony that folks (such as me) who are supposedly cancelled are anything but. We are invited everywhere to complain loudly about being silenced.

A similar disconnection from reality applies to the popular fear that equities are shrivelling up — with companies and investors shunning public markets. That share indices keep rising is conveniently ignored.

For example, the FTSE 100 has risen around 70 per cent in nominal terms in the two decades during which this so-called “de-equitisation” has occurred, while the market capitalisation of American shares has quadrupled. Smaller stocks, which have withered the most apparently, have grown their equity even more.

Hence, the UK chancellor was right this week in resisting demands to introduce a savings product that favours domestic shares. It would be the wrong solution to a problem that doesn’t exist.

Indeed, I struggle to think of anything investors and policymakers should care about less. The equity extinction view confuses volume and value, primary and secondary markets and overstates the importance of equity capital.

The absolute number of shares in circulation tells us very little about the health of a market or a company. Take Apple. The company has split its shares five times since going public 43 years ago. On three occasions investors received two shares for every one they owned. Once it was seven-for-one and another time four-for-one.

No one cheered these events as triumphs of re-equitisation — and rightly so. Apple’s share price was adjusted lower each time.

Likewise should we chastise Warren Buffett — he who has encouraged more people to invest than anyone — for never splitting Berkshire Hathaway’s A-shares? Or why not force all public companies to spin-off and list one of their divisions on the basis that this would create new shares? This would also raise the number of public companies — something else de-equitisers fret over for some reason.

The true marker of success is shareholder returns, not the equity or firm-count. Japan has twice as many listed stocks as the UK does. Needless to say, its annualised shareholder returns aren’t double, nor is its economic growth.

Returns also explain why markets have not grown more over the past decade — a complaint made by the de-equitisation brigade. Most companies pay out some of their excess profits, which reduces any rise in their market capitalisation.

For example, whereas the latter has only increased by a tenth for the FTSE 100 in the past decade, total shareholder returns, which include dividends, are 60 per cent. The return for UK small caps is more than twice as much as the rise in their market cap.

Even if share count was relevant, encouraging investors to buy local equities — perhaps by selling overseas ones — does not help. This is the second de-equitisation fallacy, born of confusing primary and secondary markets.

By all means encourage domestic investors to participate in initial public offerings. These do help companies and promote growth. But the buying of shares already issued does nothing of the sort. Cash in must equal cash out.

Similarly, equity markets do not become cheap in the long run because insurers, say, have switched to bonds for accounting purposes. Someone bought those shares, and the price at which they traded, and hence the attractiveness of a market, is ultimately a function of cash flows and other fundamentals.   

But, cry brokers such as Peel Hunt, the number of IPOs is falling! And this, it goes on to say, leads to a death loop of less interest, lower valuations, and ever fewer public listings. Worse, newer companies tend to be more dynamic, so markets ossify, as do economies.

Again, worry not. What matters is new business creation, not whether the equity raised is public or private. In the UK, new incorporations were up 13 per cent in the third quarter versus the same period last year. Compared with a decade ago, more than 90,000 more companies popped into existence between July and September — an average annual growth rate of almost 6 per cent.  

Plus there are other ways companies can fund themselves, old-fashioned loans for example, as industrial Germany knows well. What is more, why do we fuss so much over the amount of equity in existence and ignore credit?

Non-financial corporate debt outstanding is 50 per cent larger than it was a decade ago. It even grew this year as global borrowing costs were rising. Mums and dads have leapt into credit funds and made fortunes — this should be celebrated.

Of course, investor love for bonds versus equity will shift over time, as with companies. This is due to many factors, from interest rates and earnings yields to animal spirits and regulation.

Low interest rates have favoured debt financing for ages but even then, equity markets have thrived. And at the end of the day it matters not from a valuation perspective how companies raise capital, as the academics Franco Modigliani and Merton H Miller proved in the 1950s. What we always need, however, is more great businesses.

Equity can be issued, deleted, and split — just as companies can. Just don’t lose sleep about it being cancelled. 

stuart.kirk@ft.com