A primer on how equity supply can influence returns
Like any good or service, we think share prices—whether of an individual public company or a national or global equity market index—rise and fall based on the interaction between supply and demand. In the relatively near term—which we define here as the next 3 – 30 months or thereabouts—our research indicates demand tends to be the primary driver. But changes in supply can also have an impact, especially if they are large and rapid.
The idea share prices move on supply and demand means that all else constant, prices rise when eager buyers bid up shares—or when the quantity of available shares declines, since buyers must then compete for a smaller pool. Conversely, when buyers lose interest or share supply rises, prices fall. Our observation of equity markets indicates events sooner than three months away are likely to be already “priced in”—that is, reflected in share prices. We aren’t arguing markets “predict” outcomes perfectly—but they do tend to get a good sense of probabilities beforehand, in our view. Because of markets’ ability to price in all widely known public information—including speculation and probabilities—economists often describe them as “efficient.” Beyond the next 30-ish months, though, we think events are probably too far out for markets to discount probabilities, as there are many unknowns. Hence, we think markets likely can’t assess them with any real accuracy.
This means demand for shares—which we think typically depends on economic fundamentals, political factors and sentiment—is generally the main determinant of prices during that 3 – 30 month timeframe. This doesn’t mean it is impossible for share supply to change fast, impacting markets in the near term. Here are a few common ways supply changes.
New share creation
- Initial Public Offerings (IPOs)
In an IPO, a private company “goes public” by selling slices of ownership—called “shares”—to the public. All else constant, IPOs increase share supply. Going public is one way to raise capital or allow founders and early funders to recoup earlier investments. The alternatives for a firm in need of funds would be borrowing from a bank, issuing debt or raising money from private investors.
- Secondary share offerings
This is when an already public company creates more shares for sale to the public—or simply gives them directly to employees as a form of compensation. Either way, the result is the same: higher share supply.
- Spinoffs
A company undertaking a spinoff creates a new, independent firm from one of its business units or divisions. With this new company comes new shares. These are typically offered to existing shareholders, sometimes at a discount.
- Share-based M&A
M&A refers to “mergers and acquisitions,” in which one company buys or combines with another. In both cases, you start out with two firms and end up with one. If a firm funds an acquisition of another firm by creating more of its own shares—which it uses to compensate the purchase target’s shareholders—overall supply rises.
Existing share destruction
- Cash-based M&A
A firm with plenty of cash—or good credit and the ability to borrow—may opt to fund an acquisition by purchasing the target company’s shares. This, in effect, destroys them—hence, supply falls.
- Buybacks
A company purchases a given quantity of its own shares on the open market, destroying them. Firms may do this as a way to return money to shareholders or to offset supply increases from share-based compensation.
- Going private
Same process, but the company buys back all its shares—it is no longer “public.” Occasionally, a private equity company will purchase a firm and take it private as a prelude to taking it public again later (hopefully after boosting its share value). In this case, the net effect on share supply is eventually zero.
- Bankruptcy
When a firm goes under, its shares vanish with it—or another firm acquires them, usually for pennies.
In our view, near-term share supply shifts are relevant to investors in a couple ways. First, shrinking share supply can help support a bull market—or, a prolonged period of rising share prices. Second, at extremes, rapidly rising supply can be one sign of a peaking market. If new firms are going public in droves, and investors are bidding up companies with seemingly unsustainable business models, this could create a bubble. When demand falls during such a supply glut, a bear market can follow. We think this is what led to the global bear market that began in 2000, which was preceded by America’s Tech boom and a flood of IPOs, many of which lacked reliable revenue streams and burned through cash at an alarming rate. When lots of firms with weak or negative cash flow and no discernible business plan are rushing to go public, this could reflect overheating sentiment, in our view.
Over longer periods, we think share supply trends tend to dominate as demand ebbs and flows. Yet there is no way of predicting share supply changes that we know of. They depend not only on future regulatory environments, but also economic trends, interest rates and even emerging new technologies. Moreover, our research suggests that outside of the aforementioned extremes, equity supply changes usually move slowly and are priced into markets far in advance, as the mechanisms by which shares are created or destroyed are public. Hence, we think forecasting them far into the future is folly. Presently, though, share supply doesn’t seem to be shooting higher. In the US, for example, net share issuance—shares created minus shares destroyed—fell -£248 billion in Q2.[i] We think this is one sign of healthy bull market.
Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: 2nd Floor, 6-10 Whitfield Street, London, W1T 2RE, United Kingdom.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in world equity markets involves the risk of loss and there is no guarantee that all or any invested capital will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world equity markets and international currency exchange rates.
[i] Source: FactSet, as of 7/9/2018.