What is a Small Cap Market Index and why save it? The small-cap equities market in the US is in decline, overshadowed by larger players.
Sadly, many Americans are unaware and indifferent to this reality. Most people lose interest when they hear about the “small-cap equities market.” If you only follow the daily news and check the Dow Jones Industrial Average, you may have little knowledge of the stock market’s smaller players. However, this ignorance doesn’t mean you’re not impacted.
While Apple, Exxon Mobile, and Google dominate the headlines, small-cap stocks are actually responsible for creating most new jobs. Without a strong capital market, future innovators like Steve Jobs and Larry Page won’t have the necessary funds to turn their garage ideas into successful companies.
Saving the Small Cap Market Index: The Small-Cap Salad Days
Not long ago, the American small-cap market index was in an enviable place. Small-cap IPOs were plentiful, young companies with new ideas could get an influx of cash to really build something. And foreign markets looked on with envy at America’s ability to keep money flowing to the companies. Where it would do the most good.
So what happened? The choking off of the small-cap market index was largely unintentional. No one set out to make it happen (sorry, conspiracy theorists). Instead, a combination of technological progress and well-meaning regulations combined to create an imperfect storm that strangled these once-vibrant markets.
Every Reg Has its Thorn
Since the dot-com bubble burst, the markets have changed a lot. The changes have mostly been positive, making stock markets more accessible and information-rich. However, regulations have favored larger players over smaller ones.
Saving the Small Cap Market Index: The Spritzer Decree and Section 404
Two prime examples of this are the so-called “Spitzer Decree” and section 404 of the Sarbanes-Oxley Act. In both cases, they were necessary and positives reforms. But they lacked the sort of language that would adjust their effects to fit the size of the companies involved.
The Spitzer Decree, named after Eliot Spitzer, resulted from the Late Trading & Market Timing Investigations in 2003. Spitzer uncovered hedge funds and mutual fund companies involved in illegal “late trading” of mutual funds. The decree, part of a legal settlement with investment banks, prohibited banks from using fees for research products. This addressed the conflict-of-interest issue revealed by Spitzer’s investigation.
The Sarbanes-Oxley Act of 2002 was passed after Enron, WorldCom, and Tyco scandals. It aimed to restore investor trust by implementing tighter accounting regulations. Section 404 required public companies to have strict internal controls for accurate reporting.
Saving the Small Cap Market Index: Why were they important?
In both cases, the reforms were a net positive (depending on who you ask). They helped create public markets that were safer and more transparent. Allowing individual and retail investors to invest in public companies and mutual funds with confidence. However, they also demonstrated that not all stocks are created the same.
The sort of research banned by the Spitzer Decree was essential to small-cap stocks. No one needs a research report to know what Apple does. But that’s not so true for those companies that have yet to make a name for themselves.
“Spitzer basically killed the small-cap research industry,” said Dara Albright, Co-Founder of the LendIt Conference.
Sarbanes-Oxley, meanwhile, created a range of new expenses for all public companies. For larger firms, the new expenses were (arguably) more than manageable. But for a struggling small-cap company? Now, the basic costs of going public represent a heavy burden. At a time in a company’s life cycle when every penny matters.
However, reforms like the Spitzer Decree and Sarbanes-Oxley are just pieces of a larger puzzle. In fact, the change that may have had the biggest negative effect on the health of small-cap markets was the seemingly innocuous change in tick sizes.
Tick Size Matters
Understanding the mechanics of stock trading is not essential to grasp the market. Many people with limited market knowledge, like 401k holders or those investing in a few online-researched companies, can still do well without knowing specific sale details. Therefore, not knowing about “tick sizes” is forgivable for many investors.
That doesn’t mean it’s not exceedingly important, though.
Tick sizes are the lowest price increments used when buying and selling stocks. Before April 2001, stock prices were quoted in fractions of a dollar. However, since then, tick sizes have been normalized at a penny, which is called “decimalization.” This change had a significant impact, especially for market makers.
Saving the Small Cap Market Index: Market Makers the Key to Liquidity in Small-Cap Markets
Stocks require market makers to provide liquidity and facilitate trading by buying and selling shares. They create a pool of shares, similar to leaving slack in a rope to allow for smoother machine operation. Without market makers, buyers or sellers may struggle to find enough counterparties to complete their transactions.
Market makers profit from the bid-ask spread. Bigger tick sizes meant larger profits. However, as exchanges went digital, market makers became obsolete.
They were still necessary, but their presence was becoming less and less valuable for the biggest stocks.
“[A STOCK LIKE] APPLE IS INNATELY LIQUID. TENS OF THOUSANDS OF INVESTORS ARE WATCHING APPLE EVERY MINUTE OF EVERY DAY,” DAVID WEILD, THE FOUNDER OF WEILD & CO. AND THE FORMER VICE CHAIRMAN OF NASDAQ, TOLD EQUITIES.COM. “APPLE IS FOLLOWED BY MANY, MANY STOCK ANALYSTS ON BOTH THE BUY- (INSTITUTIONAL INVESTOR) AND SELL-SIDE (WALL STREET FIRMS LIKE MORGAN STANLEY (MS) AND GOLDMAN SACHS GROUP INC. (GS) ). APPLE TRADES ‘SYMMETRICALLY,’ WHICH IS TO SAY THAT THERE ARE LIKELY HUNDREDS, IF NOT THOUSANDS OF BUYERS AND SELLERS OFFSETTING EACH OTHER AT ANY GIVEN POINT IN TIME.”
Decimalization greatly benefited big stocks as it increased the amount of money going to investors and companies instead of market makers. Despite only earning a penny per share, market makers still profited due to the high trading volumes of mega-cap companies.
Saving the Small Cap Market Index: Small-Cap Markets Driven by Bid-Ask Spreads
However, the markets aren’t just made up of mega-cap companies like Apple. There’s also a lot of small-cap companies out there struggling to carve out a place for themselves. For them, liquidity is a lot harder to come by.
“SMALL-CAP EQUITIES OFTEN TAKE CONSIDERABLE TIME TO BREAK THROUGH THE NOISE AND FIND AN INVESTOR AUDIENCE.” SAID NEAL WOLKOFF. THE FORMER CEO OF THE AMERICAN STOCK EXCHANGE AND FOUNDER OF WOLKOFF CONSULTING SERVICES, TO EQUITIES.COM. “UNTIL THAT TIME COMES, THEY NEED TO BE VIEWED DIFFERENTLY FROM FORTUNE 500 COMPANIES. WHOSE STOCKS HAVE GREATLY BENEFITTED FROM THE REDUCTION IN TRANSACTION COSTS BROUGHT ABOUT BY DECIMALIZATION. WITH SMALLER CAP COMPANIES, TRADES TEND TO HAPPEN LESS FREQUENTLY. AND PRICE MOVEMENTS CAN BE MORE VOLATILE THAN THEY ARE WITH LARGE CAPS. THE RISK TO THE MARKET MAKER/INTERMEDIARY TO TAKE ONE SIDE OF A TRADE IS GREATER. WHEN HE MAY NEED TO HOLD THAT POSITION BECAUSE OF LIMITED LIQUIDITY. AND FACE THE RISK OF AN ADVERSE PRICE MOVE.”
So, when saving small cap market index small-cap stocks appeal to market makers much less than a company like Apple.
Unfortunately, small-cap companies also need those market makers way more than Apple.
“[MOST] MARKETS REQUIRE AN INTERMEDIARY TO PROVIDE A QUOTE THAT ALLOWS A TRADE TO HAPPEN AT A FAIR PRICE, AND AT A TIME WHEN THE INVESTOR WANTS HIS EXECUTION TO OCCUR,” WOLKOFF ADDED. “REMOVE THE MARKET-MAKER, THE BROKER, AND THE DEALER FROM THE MARKET. AND THAT PROCESS DISCOURAGES INVESTOR PARTICIPATION AND HARMS AN ISSUER WHO IS TRYING TO BUILD A FOLLOWING”. WEILD AGREES.
“SMALL COMPANIES ARE INNATELY ILLIQUID. VERY FEW IF ANY INVESTORS ARE WATCHING A GIVEN SMALL COMPANY STOCK AT ANY POINT IN TIME,” HE SAID. “THE SMALL COMPANY MAY HAVE NO EQUITY RESEARCH COVERAGE FROM EITHER THE BUY. OR SELL-SIDE AS WALL STREET LOSES MONEY COVERING SMALL COMPANY STOCKS. SMALL COMPANY STOCKS TRADE ‘ASYMMETRICALLY‘. WHICH IS TO SAY THAT WHEN THERE IS A BIG BUYER IT IS UNLIKELY THAT THERE WILL BE A MATCHING SELLER. AND WHEN THERE IS A BIG SELLER IT IS UNLIKELY THAT THERE WILL BE A MATCHING BUYER.”
Smaller tick sizes meant better efficiency for the major companies.
Though it also erased the incentive market makers needed to offer support to smaller players.
“MARKET MAKERS … WOULD BUY AT THE $10.00 BID AND SELL AT THE $10.25 ASK PRICE. BOOKING A HANDSOME 25 CENT PROFIT,” SAID WEILD. “AS A RESULT OF THESE RICH INCENTIVES, MARKET MAKERS DEPLOYED QUITE A BIT OF CAPITAL TO SUPPORT THE ‘ASYMMETRICAL.’ TRADING NATURE OF SMALL COMPANY STOCKS AND MAKE THEM TRADE ‘SYMMETRICALLY’ …. THESE SMALL-CAP MARKETS WERE LIQUID AND PROFITABLE. AND SO WALL STREET INVESTED IN THEM WITH RESEARCH, BROKER SALES ATTENTION, AND CAPITAL COMMITMENT. THIS ATTRACTED INVESTMENT DOLLARS FROM SOPHISTICATED INSTITUTIONS, WHICH CAUSED STOCK PRICES TO RISE AND MORE COMPANIES TO GO PUBLIC.”
“IN 1998, THE US CONVERTED TO ELECTRONIC MARKETS WITH SMALLER AND SMALLER PRICE INCREMENTS. THIS WAS THROUGH SOMETHING CALLED ‘REGULATIONS ATS’ (ALTERNATIVE TRADING SYSTEM). IMMEDIATELY, THE $0.25 PRICE INCREMENT COLLAPSED TO 1/32 OR $0.03125 PER SHARE. THAT CAUSED AN 87.5% LOSS IN MAXIMUM PROFIT INCENTIVE FOR WALL STREET TO MAKE MARKETS IN SMALL COMPANY STOCKS – OVERNIGHT. … AT ONE CENT TICK SIZES, WALL STREET LOSES MONEY SUPPORTING SMALL COMPANIES. SO THEY REALLY HAVE CUT THEIR SUPPORT OF SMALL COMPANIES TO THE BONE.”
Saving the Small Cap Market Index: A Safer, Healthier Market…Unless You’re the Little Guy
Overall, these reforms have improved the market by reducing fraud and corruption, making it friendlier for investors. However, they have also resulted in a lack of after-market support for struggling companies, discouraging them from going public.
“THE UNITED STATES NOW HAS THE LOWEST TICK SIZES IN THE WORLD, AND THAT THIS HAS CAUSED AN ABANDONMENT OF SUPPORT FOR SMALL COMPANY STOCKS, CAUSING THE US SMALL IPO MARKET TO DROP FROM 1ST PLACE TO 12TH PLACE,” SAID WEILD. “HOWEVER, WEIGHTED FOR THE MUCH LARGER SIZE OF OUR ECONOMY. THE UNITED STATES IS NOW IN 24TH PLACE OUT OF THE 26 MARKETS, AHEAD OF ONLY MEXICO AND BRAZIL. WE THINK THIS HAS HAD A DISASTROUS IMPACT ON THE US ECONOMY.”
From 1980-2000, there was an average of 311 new IPOs a year.
From 2001-2009, that number plummeted to 102. In and of itself, that two-thirds decline in IPO volume is disconcerting. However, it’s even more pronounced for small companies – a more-than 80% decline from 165 a year to 30 a year. With little to no support for small caps, and increased costs of being a public company even as the benefits have steeply declined, fewer and fewer firms see any good reason to take the plunge.
By now, some readers are undoubtedly wondering “Why should we care?” Is it just because we love the plucky underdog? Are we suggesting this is a serious issue solely because we admire the fighting spirit of these small caps?
No. The reason why it should matter to everyone is because those start-ups are the primary, if not the only, source of job growth in our economy. A system that enriches larger companies at the expense of small caps’ ability to raise capital chokes off economic growth for everyone. It’s bad news for Main Street and Wall Street alike.
Saving the Small Cap Market Index: Start-Ups are the Engine of Economic Growth
Big, established companies may employ the majority of American workers, but they’re also stagnant in terms of growth. When taken as a whole, the jobs they add are more than counterbalanced by the ones they eliminate. Not so for a start-up. These are aspirational companies, bringing new ideas to the market that can create new economic activity.
A Kauffman Foundation paper by Tim Kane reveals that from 1992 to 2006, firms in their first year of existence created an average of three million jobs a year. Those numbers rapidly decline by the second year. Particularly when you factor in just how many jobs don’t exist anymore.
In fact, since 1977, start-ups have created about three million jobs a year, plus or minus a couple hundred thousand. For existing firms, that figure was only positive one out of four years. More often than not, existing companies show a net loss in jobs.
“THE LACK OF ECONOMIC INCENTIVE HAS CAUSED THE NUMBER OF IPOS TO DROP FROM A PROJECTED 900 IPOS A YEAR TO AN AVERAGE OF 140 IPOS A YEAR, AND THE NUMBER OF NASDAQ- AND NYSE-LISTED COMPANIES TO DROP FROM A PROJECTED 13,000 PUBLICLY LISTED COMPANIES TO 5,000,” SAID WEILD.
The lesson? Mega-cap companies are good, but their growth is limited. They don’t create many new jobs. Small-caps and start-ups are the ones that matter for job creation.
Liquidity Keeps Small-Caps Solid
To boost the US economy, it’s crucial to support small businesses with easy access to funds. Liquidity in the stock market is vital for raising essential capital, enabling start-ups to become successful like Apple or Walmart.
“A LIQUID STOCK SERVES AS A FORM OF CURRENCY FOR ACQUISITIONS, COMPETITIVE COMPENSATION AND HIRING OF NEW TALENT,” SAID WOLKOFF. “A LIQUID EQUITY MARKET IS ALSO ESSENTIAL FOR THE COMPANY TO BE ABLE TO FURTHER FUEL ITS GROWTH THROUGH THE CAPITAL MARKETS BY RETURNING FOR SUBSEQUENT ISSUES WHEN GROWTH DEMANDS NEW CAPITAL.”
This is something that R. Cromwell Coulson, President and CEO of OTC Markets (OTCM) when Equities.com spoke with him.
“THERE’S LOTS OF ACADEMIC RESEARCH THAT SAYS MORE LIQUIDITY LOWERS YOUR COST OF CAPITAL,” SAID COULSON.
But liquidity for smaller companies doesn’t come easily.
The small cup market is risky. Small-cap stocks are volatile and have bigger price swings. This can lead to either big gains or big losses. It scares away many investors. Investing in IBM is safer but less profitable.
Liquidity is easier to acquire when you already possess it, but harder to generate if you don’t. Stocks with low liquidity are difficult to trade, deterring potential investors. Selling an illiquid stock may result in a price drop before the sale is executed, increasing risk.
That, unfortunately, has a snowball effect.
The increased risks scare away a lot of investors, which reduces liquidity even further, thereby increasing risk even more, which scares away more investors, which reduces liquidity…see where I’m going with this? It’s a vicious cycle.
Saving the Small Cap Market Index: Are Private Markets the Solution?
Some argue that companies now depend on private markets for capital, avoiding going public in favor of venture capital and then selling to larger firms. However, even if this is true, it still signifies a concerning new vision of our capital markets.
“WITH SUCH INHOSPITABLE STOCK MARKETS, MERGERS AND ACQUISITIONS HAVE BECOME VIRTUALLY THEIR ONLY OUTLET TO REALIZE VALUE FOR THEIR HARD WORK,” WROTE WEILD IN A 2011 OP-ED FOR THE WALL STREET JOURNAL. “AND AS WE’VE SO OFTEN SEEN DURING THIS TOUGH ECONOMY, M&A GENERATES JOB CUTS, NOT NEW JOBS.”
Publicly-traded companies benefit from providing everyone the opportunity to purchase their stock. Public markets allow anyone to participate in corporate profits, even if indirectly through a mutual fund in a 401k. This gives Main Street a chance to participate.
This is not the case for most private financing
The JOBS Act allows for new ways of raising private capital, but non-accredited investors still have limited options. Accredited investors have more opportunities due to their net worth or income.
Due to a shortage of small-cap IPOs, non-accredited investors are missing out on potential high returns from start-ups. Although stock trading is accessible to most, opportunities for retail investors are decreasing. Instead of companies seeking capital from the public and sharing success, the economy seems to be favoring the wealthiest investors for maximum returns.
And this point shouldn’t be overlooked.
Public markets allow any American to share in the profits of big corporations, making them a democratic force in our economy. Private equity markets, in contrast, are more elitist and exclusionary.
Including all Americans in the nation’s prosperity is crucial for capital markets. This can be achieved through mutual funds or ETFs bought by 401ks or pension funds. Encouraging startups to go public instead of relying on private funding promotes an inclusive American economy.
Saving the Small Cap Market Index: The Definition of “Small” Gets Bigger
How can we help start-ups and small-cap companies raise money easier? How can we make the capital market more accessible to all, not just the rich and big companies? Is it possible to make the needed changes?
Short answer: Yes. This is hardly a situation that can’t be remedied. Investing in small-cap stocks is actually one of the best investments you can make. Sure, there’s volatility and risks that don’t exist in fixed income or large-cap stocks, but the potential for higher returns more than make up for that.
“THE DEFINITION OF WHAT’S SMALL HAS GROWN IF YOU’RE TALKING ABOUT THE INVESTMENT PERSPECTIVE, BECAUSE RESEARCH HAS REALLY BEEN CUT BACK IN THE SMALL-CAP ARENA. IT REALLY PROVIDES FOR A LOT OF OPPORTUNITY,” ROBERT MALTBIE, MANAGING DIRECTOR AND FOUNDER OF SINGULAR RESEARCH, TOLD EQUITIES.COM. “IF YOU DO YOUR HOMEWORK, YOU CAN ACTUALLY FIND COMPANIES THAT RUN UNDERCOVER, FORGOTTEN, MISUNDERSTOOD, OR NOT UNDERSTOOD AT ALL. THEY’RE MISPRICED, CONSEQUENTLY THAT’S WHERE THE REAL OPPORTUNITY IS.”
What’s more, there’s arguably more opportunity to build a healthy market and saving the small cap market index for small-cap stocks than ever.
The internet revolutionized regulations for small caps, but it also provided small-cap investors with abundant company information, comparable to resources available to top bankers decades ago.
“WHEN YOU THINK ABOUT THE QUALITY OF AN EXPERIENCE THE INVESTOR CAN GET FROM THEIR ONLINE BROKER IN THE PAST 15 YEARS, HOW MUCH THAT’S CHANGED, IT’S UNBELIEVABLE,” SAID COULSON. “THE AMOUNT OF DATA THAT’S OUT THERE, THE VERY PLACES THEY CAN GO FOR FREE DATA TO PREMIUM DATA, THE COMPETING SERVICES ON THE INTERNET. THE EASY ABILITY TO LOOK AT NOT ONLY TRADING DATA FROM THE COMPANY, BUT COMPANY DATA, COMPANY IR WEBSITES…”
By making sensible changes and regulations, we can revive small-cap markets and bring prosperity to small-cap companies like never before.
Saving the Small Cap Market Index: Small Change is in the Air
One positive change could already be on the way. The SEC heard the cries about how penny tick sizes were killing the opportunity for market makers in small-cap markets, and put together the Tick Size Pilot Program to address the issue.
The pilot will take companies with a market cap of $5 billion or less and a per-share price of at least $2 and offer the chance for participants to trade with a tick size of $0.05 for one year. If this demonstrates increased liquidity and support from market makers, the odds are good that the drum beat for change could continue to crescendo.
Take All Your Problems, Break ‘em Apart
Additionally, the “right-sizing” of some other regulations could further improve conditions. Certainly, overturning Sarbanes-Oxley or the Spitzer Decree in their entirety isn’t in the cards. However, creating exceptions in these rules for those companies that are struggling to get by could reap real benefits.
Sarbanes-Oxley was driven by the collapse of major companies like Enron and WorldCom, which posed a systemic risk to the stock markets. These companies were considered safe investments found in 401ks and low-risk mutual funds. In contrast, small-cap stocks do not carry such risks. Failure or scandal is expected with small-cap stocks, and while it may harm individual investors, it will not threaten the entire market.
And, to be sure, easing regulations like these does increase the risk of fraud.
Small-cap markets are prone to fraud, and relaxing regulations won’t solve the problem. However, there are alternative methods to mitigate the impact of dishonest actors and preserve opportunities. Accepting a few bad apples in order to foster a fruitful environment is reasonable, as long as we continue developing strategies to identify and eliminate them.
Conflict of interest in research reports is a serious problem. However, if disclosed, investment banks using fees to introduce small-cap companies to clients could encourage investors to explore overlooked markets. This could help manage the issue on a smaller scale.
Both of these were among the recommendations made by President Obama’s Jobs Council in 2011, and the proposals there provide an excellent framework for potential reforms.
As Goes the Saving the Small Cap Market Index…
The US economy relies on a healthy small-cap market index, which many Americans don’t fully grasp. Capital markets that support entrepreneurs and innovators generate jobs and prosperity. Whether employed by a large corporation or a new start-up, everyone benefits when small-cap players can showcase their ideas in the open market.
Ensuring incentives guide capital to where it’s needed should be obvious. However, markets have suffered in the last 15 years. Though changes were well-intentioned, we must evaluate their impact and make reforms to maximize our public markets.
