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Felix Salmon on the death of equities

by Robert Teitelman | Published February 14, 2011 at 1:10 PM

Reuters blogger Felix Salmon leaves the digital future temporarily to take up residence on The New York Times' analogue op-ed page (I know, there's a digital version too). Salmon's subject is provocative: In light of the tempest stirred up by the mooted merger of Deutsche Borse with the New York Stock Exchange, he worries less about the deal as a sign of American decline and more as, the headline bolted to the column says, "Wall Street's Dead End." In Salmon's own words: "The stock market is becoming increasingly irrelevant -- a trend that threatens the core principles of American capitalism." And why is this bad? Because it marks the failure of the grand experiment in shareholder democracy and is another symptom of inequality. There's a lot here to think about. Salmon's key statistic is the fact that "major domestic exchanges" peaked at some 7,000 listed companies in 1997, and has now fallen to 4,000. He expects that number to continue to decline. And he argues that those companies are not the most innovative ones, the "technology stars like Facebook and Twitter," but rather "the biggest and oldest." As a result, the stock market "is becoming little more than a place for speculators and algorithms to compete over who can trade the most money."

In other words, dead end. How do we sort this out? Salmon makes a very good point. The stock market has changed over the last 40-some years, particularly since 1975 when stock commissions were freed. Volumes have mushroomed, shares turn over at a much greater rate, and after a period when listings steadily grew, there has been a decline attributed to several causes: a dearth of initial public offerings, particularly after the dot-com bust, and a viable option for companies (and their investors) on the private side of the house, private equity. Salmon sees the last half a century as an era where shareholder democracy has been "forged." The real danger to this development threatening American capitalism is that those mass shareholders would have only the dregs to invest in -- not the Facebooks and Twitters.

This is overstated on several fronts. Start with American capitalism, as defined by Salmon. In 1952, when John Kenneth Galbraith wrote his "American Capitalism," he paid no attention to shareholder democracy; in fact Galbraith viewed the stock market as the dangerous vehicle that had almost destroyed American capitalism in the Great Depression and viewed its corporate role as minimal. The stock markets had scant institutional presence; volumes were low and driven by individual investors who mostly engaged in, well, speculation. As institutions moved into the market in the '60s they drove reforms that later gathered under the banner of shareholder democracy: the shareholder as owner and monitor, the development of defined contribution plans, the continuing drive to greater competition, lower price, higher performance. Salmon also isn't the first to see the stock markets near death: There was the famous BusinessWeek cover in 1980 declaring "The Death of Equities." Unfortunately for BW, stocks and shareholder democracy took off in the Reagan '80s with the development of junk bonds and a wild M&A market, plus the decisive shift toward individuals investing for their retirement in stock mutual funds. And, of course, there was the promise of tech stocks, like Apple, Intel and Microsoft, which fueled the market and gave it sex appeal (the appeal of tech goes back to the '30s with RCA and the radio stocks, but took off again in a bubbly tech rally in the '60s).

By the '90s the tech mania crested, with both Internet and telecom issues. It's no surprise that Salmon's 7,000-issue crest occurs in 1997 and swoons with the collapse of the dot-com bubble in 2000. Salmon seems to view that era with nostalgia. In fact, it was a period of intense speculation -- always a large element in investing in stocks whose futures are still many years ahead, the reason Warren Buffett always avoided them. The collapse of that bubble, and the scandals that followed like Enron and WorldCom, effectively killed off the IPO market for years and dealt a serious blow to venture capital. It's true, after 2002, the private equity business launched an unprecedented boom, climaxing in 2007, which took a large number of public companies private. But even if you could eliminate private equity as a factor, it's unclear whether the supply of new companies through IPOs, particularly the tech paragons Salmon believes drives the whole show, would have been all that much greater.

Indeed, Salmon fails to mention what may be the real reason for both the rise of private equity and the migration toward private status: corporate governance, otherwise known as shareholder democracy. The great experiment in shareholder democracy, which began with the reforms of the '70s, has been a failure. The experiment hinges on the ability of shareholders to actively monitor corporate behavior, including compensation. Shareholder democracy has produced a strange situation: on one hand, a fixation on short-term share prices by corporate managers and increasing attention paid to shareholder demands and requests; and, with the exception of hedge fund activists, a profound passivity from large institutions, deepened by an increasing share of the market that's indexed or closet indexed. Shareholder advocates reject this view; they see every disaster as an argument for greater shareholder powers. But the truth is we've created an increasingly bifurcated market: intense speculation on one hand and deep passivity on the other. And this bifurcation can be traced back to the dynamics of shareholder democracy itself.

Now there are many reasons that public corporations might opt to go private. There's plenty of capital out there to make it worth their while, they no longer have to hit quarterly targets and please a large and restless shareholder group, and there is less disclosure and fewer rules. But the larger reality is that private equity, with its compact shareholder group, mostly tends to meet the requirements of active oversight and clearly articulated governance. It also normally sells off the company after a number of years, sometimes in an IPO. Last year the IPO market was dominated by private companies going public again, evidence that the real problem with tech stock lays within the tech community, notably venture capital, itself. (This is complicated too. There are a lot of crosscurrents coursing through the startup world: For some startups, costs are extremely low, but hurdles to IPOs are quite high. And there is a lot of capital to keep startups private longer.)

Salmon may be right: A shrinking population of public companies may be a sign of pernicious inequality, driven by Wall Street. But while you can ascribe all kinds of malign motivations -- read: greed -- to the rise of private equity, its evolution has been shaped by the demands of efficiency in the corporate market. For years, private equity focused on the low-growth, steady cash flow businesses within the middle market. These were companies that tended to be overshadowed and undercovered in public markets, particularly after equity research contracted as a result of Eliot Spitzer's Analysgate settlement. Private equity provided capital and advice and, yes, through debt and dividends, made a lot of money at it. Over the previous cycle, private equity began to expand into other areas, like tech or big-cap companies, only to be scorched by the credit crisis. But for a number of decades now the business has provided an exit and financing for companies that simply lacked good options.

Salmon is also correct that we may have a problem, particularly since the great mass of Americans have little choice but to invest in the stock market for their own retirement, although he doesn't mention that the 401(k) menu has generally expanded over the years, with a greater diversity of funds, and greater reach overseas. (Whether retail investors can -- or should -- wisely invest in those options, particularly in tech stocks, is another question entirely.) But on the altar of shareholder democracy we have erected a number of expectations that are impossible to meet: the freedom to invest where you want, the "right" to high (or at least steady) performance, the funding of cutting-edge innovators, the oversight of public corporations, the attainment of both democracy and profits. That's a burden that's not only heavy but in many cases paradoxical. No wonder it's not working. - Robert Teitelman

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