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 This is not only bad news for investors in IPOs, but may also have
significant repercussions on equities generally.
Studies over the past decade have shown that successive generations
of IPOs through the decades are performing worse; they grow more
quickly than their forebears but with greater volatility and more
failures.
A recent study finds that this reflects heightened competition as
the world has moved away from simply making things and pivoted
toward producing higher-valued goods or services, but in much more
competitive areas.
"Firms from successive cohorts (of IPOs) enter more
knowledge-intensive industries. Even within the same industries,
successive cohorts use higher levels of intangible inputs," Anup
Srivastava of Dartmouth College and Senyo Tse of Texas A&M write in
the study. "Furthermore, new cohorts operate in product markets
characterized by higher uncertainty and competition." (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2724081)
In part, this is nothing more than the flipside of the globalization
of manufacturing jobs to cheaper offshore locations. That move away
from commodity-type manufacturing leaves U.S. companies to compete
in areas with more intangible inputs. When you compete on the
strength of your talent, of your technology and of your research and
development, you are subject to much higher volatility in the market
than companies from an earlier era.
That's clearly reflected in the performance of IPO cohorts as
documented in the study. Firms listed in the 2000s show share price
volatility higher than those listed in the 1990s, 1980s, 1970s or
before 1970. Earnings volatility is also much higher; for example,
about 10 times higher for firms that went public in the last decade
vs those that went public before 1970.
Research and development spending has also moved higher over time,
while newer firms also use less in the way of material inputs but
must compete in more fragmented and competitive markets. The study
found that the underlying reason for the changes in performance are
the differences in operating conditions.
While this is positive, in that it shows that companies are becoming
more innovative, the world of today offers less security. So good
for consumers, perhaps, but not so great for investors, who must be
prepared to endure a wilder ride.
So while today’s IPOs innovate more, offering more new products,
this is because they must, as the markets in which they compete are
also innovating at a more rapid rate. That greater rate of creative
destruction is reflected in the higher number of firms from later
IPO generations that fail.
JUST IPOs OR THE REST?
Note too that this is all not simply a tech industry phenomenon.
While Blackberryhas seen its lunch eaten by Apple, the study found
that industries outside tech are showing the same trends. Successive
generations of companies in a range of sectors are using more
intangible inputs to create value and are competing in more volatile
and tougher environments.
All of this may also help to explain why, while profits are more
volatile and more are failing, the distribution of profits among
companies is skewed more to the right, meaning there are more very
highly profitable companies.
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Firms that rely more on intangibles, like talent and R&D, tend to
have higher fixed costs, which leads to higher losses earlier in
their life cycle. However, they find it comparatively cheap to scale
up production, which leads to profit monsters like Apple.
Earlier studies have posited that the declining performance of IPOs
was explained by the age at which firms tend to go public. As firms
have tended in more recent decades to go public earlier in their
lives, they would, this argument holds, show more volatility in
performance than more seasoned firms.
If that were true, Srivastava and Tse argue, then risk levels among
newer cohorts should decline as the unviable fail.
“We find persistent and substantial risk differences across listing
cohorts even after several decades. In addition, we find no evidence
that new-list firms’ operating characteristics converge toward those
of seasoned firms. The intangible intensities and product market
characteristics of successive cohorts remain distinct,” they write.
The larger question not answered by the study is what this means for
companies and equity investing generally.
My guess would be that it implies tougher overall conditions, with
greater distance between the performance of big winners and the
rest. Over time the economy itself is shifting more toward areas
with higher inherent levels of competition and volatility.
Remember too: This is happening over an extended period. It isn't
just capturing a one-off rise in risk due to digitization or the
internet. This seems permanent and pervasive.
How investors price this rise in risk remains to be seen. We
probably won't get a clear view on this until interest rates rise.
(James Saft is a Reuters columnist. The opinions expressed are his
own.)
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by Dan Grebler)
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