8/31/2010 6:00 PM ET|
How the stock market is killing jobs
The decline in IPOs also hurts early-stage developmental companies -- think two geniuses in a garage cooking up the next Google (GOOG, news). That's because venture capital firms use IPOs to cash out and free up capital to invest in new startups. "If they can't get exits, they have trouble raising more funds," says Kim.
He believes the decline in IPOs helps explain a relative decline in early-stage investing in capital-intensive industries such as semiconductors and drug development, in favor of social-networking websites that need far less capital.
"The decline in listings has serious implications for the economy," agrees James Angel, a stock market expert and professor of finance at Georgetown University's McDonough School of Business. "Without new listings, we basically have no new companies in the long run."
The 'Great Delisting Machine'
What's caused all this? Weild and Kim blame it on the "Great Delisting Machine." That's their moniker for the series of regulatory and technological changes that lowered commissions and democratized the stock market.
Before the mid-1990s, brokerages might have charged a $60 commission for a trade, and they quoted stocks with 25-cent spreads between the bid and the ask -- the price you sold a stock for and the price you bought it for. (The brokerages pocketed the difference.)
Regulatory changes took that bid-ask spread down to pennies, allowing virtually anyone to post quotes inside the bid and the ask, instead of just brokers and exchange specialists. Online brokerages knocked commissions down to just a few dollars a trade.
Here's one of the things we lost in that bargain: Old-school brokers used the profits from those commissions and the bid-ask spread to fund an ecosystem that supported small companies. They funded analyst research on small-cap companies, sales teams to work the phones and sell a company's story, and trading desks with enough capital to smooth out price moves in small-cap stocks by juggling supply and demand (all for more profit, of course).
All that's gone now -- and with it, a market that used to be friendlier to small companies. Now, small-cap research is scarce, so it's hard for investors to understand these businesses. The stocks can also swing wildly, because there are no trading desks committed to helping them grow.
"We think we automated in the name of progress and lower costs," Weild says. "But this ideology that faster and cheaper is better is incredibly misguided, and it's doing grave harm to the U.S. economy."
To bring back the old system, regulators such as the Securities and Exchange Commission would have to exempt a new exchange from the rules that killed the old system. But this is doable.
Pipeline Trading Systems, an alternative trading system that uses technology to help money managers disguise their intentions in the market, exists because it got exemptions from regulations -- like the requirement to openly display quotes in its system. Pipeline Trading Chairman Al Berkeley believes a new exchange for small-cap stocks is worth experimenting with, and he thinks regulators might be open to it. "The SEC is very sensible about this," he says.
Of course, not everyone believes we need a new stock exchange. "The global stock markets are not fundamentally broken," says Scott Laue of Savant Capital Management. Market Profile Theorems research director Michael Painchaud thinks theories about a broken stock market are just part of the overwhelmingly negative sentiment toward stocks.
3 small-cap buys
Painchaud also thinks the shortage of research on small-cap stocks can actually help investors, because it creates opportunities for anyone who does the homework needed to find good, undervalued companies.
A great example of this is the LSGI Technology Venture Fund, run by Joe Dancy. His fund has produced 11% annualized returns during its 11-year life -- compared with 4.6% returns for the Russell 2000 Index ($RUT.X) small-capitalization index -- by digging up cheap small-cap stocks with good prospects.
"Most folks don't have the time to research microcap firms, and institutions are ignoring them," Dancy says. He believes the current rush to bonds has particularly punished microcap stocks, creating some "incredible" opportunities for long-term investors. "Stock valuations for small companies are way out of line with their true value," says Dancy.One small company he likes is oil and gas producer GeoResources (GEOI, news). The company's expected production is worth $22 a share, says Dancy, but the stock sells for just $14.70. He also likes Evolution Petroleum (EPM, news), a domestic crude-oil producer that revives old oil fields by injecting them with carbon dioxide, which helps oil flow. This company's future production is worth $10 to $12 a share, but the stock sells for under $5 a share.
A third favorite is Ebix (EBIX, news), which sells software used by insurance companies that's increasingly popular. LSGI owns all three stocks. But wait a minute. If these stocks look cheap because they're ignored by the market, won't they always remain cheap?
Not really. You might have to be patient, but sooner or later, they can pay off big. With relatively few shares in the market, stock prices can rise quickly when a company's story catches on. And if investors fail to recognize these companies, competitors will -- and take them over. Shares of network security software company ArcSight (ARST, news), also an LSGI holding, shot up 39% last week when news leaked that it was shopping itself around.
"The merger-and-acquisition frenzy has just begun," says Dancy. "In a slow-growth economy, what better way to expand than by buying a fast-growing, profitable small- or microcap firm that is undervalued?"
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
At the time of publication, Brush did not own shares of any company mentioned in this column.
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