Why the stock market doesn’t always work

I’m a big fan of the stock market. After all, I’ve spent the last 32 years of my life engaged with it professionally.

It’s been the basis of my long career in equity fund management, and for the last year or so, I’ve been writing about it in Penny Sleuth and Red Hot Penny Shares. But a throw-away comment in the last edition of Penny Sleuth set me thinking:

What is the stock market really for?

When you’re closely involved in something every day, you rarely, if ever, question its validity. I suppose there’s always a fear that if you examine it too closely, you might realise you’ve been wasting your life!

Happily, I don’t think that’s the case with the market. It serves a few really important functions, and in the main, it does these well.

Last week, I said that the stock market’s main purpose was to connect those of us who have savings to invest with companies who need risk capital to fund their operations.

The market is an especially good mechanism to do this. Because it brings all these interested parties together in one place, we stand the best chance of pricing things accurately.

It’s like one massive, continuous auction. Lots of companies competing for capital and investors competing for the best opportunities means we should have an efficient marketplace.

By that I mean that profitable, well-run companies will always attract investors and flourish, while poorly-managed, stale companies will eventually run out of profit and investors.

And this idea is also critically important for the economy as a whole…

A state-run stock market would be a nightmare!

If capital is allocated efficiently – if we let investors choose which companies to invest in and therefore which thrive and which don’t – then as a nation we will be productive.

That, for me, is the stock market’s crucial role – even more crucial than allowing smart penny share investors to make money (but only just). It allows the stock market to follow Darwin’s law of the survival of the fittest. The best companies, the strong ones, will prosper. The weak ones will not.

The alternative is to let a civil servant try to run the stock market. Or worse, a committee of civil servants! Crowds tend to be a lot wiser than even the cleverest individuals.

Admittedly, there are some things that don’t lend themselves to a market solution – what economists call “public goods”. Defence is a classic example. It’s something that has to be provided collectively.

Some industries like transport, education and healthcare fall into a grey area. We can have a political argument about how beneficial government interference is in these cases – High Speed 2 rail link anyone? But I’ll admit some overarching national direction is needed here.

But while the free market might need a helping hand in some areas, I’m convinced ministers and civil servants should keep their paws out of industry and leave it up to the market.

So, the stock market is nature’s way of allowing the best companies to raise funds to develop, expand and thrive.

But that raises another question: is the stock market itself always the best route for companies raising money?


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Why the stock market isn’t always the best answer

Part of the reason the stock market works well is that it allows investors to trade their shares. This liquidity means the pool of capital available is much larger than it would be if investors were locked into their holdings for a period. It also means the equity is cheaper for companies – investors won’t demand as high a return if they can sell easily.

However, some investors are prepared to be patient, long-term holders and they can provide an alternative approach for companies trying to raise capital.

An announcement from IP Group (IPO) the other day reminded me of this.

IPO is an investment company focused on early-stage businesses which are commercialising technology spun-off from our university system. One of its investments is in Oxford Nanopore, which I’ve written about before.

Back in 2005, IPO provided the initial private funding for Oxford Nanopore. This enabled IPO to gain an almost 20% stake in the business. Oxford Nanopore has continued to raise money privately since then – in fact, the company has just raised another £35m via a private placement. This means it has raised a total of £180m since 2005.

This would be a pretty impressive high-tech new issue by London Stock Exchange standards. But this money has been raised privately.

The company hasn’t been exposed to the wisdom of the market crowd. Although it does have quite a broad investor profile for a private company, its cost of funding will no doubt have been more expensive than the stock market would have delivered.

But I suspect the big benefit that Oxford Nanopore has had from taking this path is the patience and support of its investors.

New tech companies need a longer-term view

Companies do need to be put under pressure to deliver, but in the early-stage tech world, things rarely run smoothly. Milestones and targets can get delayed a little.

Being held up by a couple of months shouldn’t be the end of the world. But for a listed stock, such modest disappointments can be taken badly. Investors can easily lose confidence and valuations suffer as a result.

In the private market, investors are more likely to be close to the company and prepared to take a longer-term view. Of course, in one sense they have to! Limited liquidity means it’s a lot harder to get out if you lose faith.

Those young companies that instead choose to join the stock market can end up struggling if they miss some of those targets. As a micro-cap investor, I see plenty who lose their way having probably come to the market before they were ready. Those stocks that stagger over the line and get listed with very little institutional support will struggle if the mood turns sour.

So yes, I think the stock market is great – great for companies that are sufficiently well-run and developed to use it properly. But as Oxford Nanopore shows, there are alternatives that might suit some companies better.

This article is taken from our FREE penny share investment email Penny Sleuth.
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Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do

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3 Responses

  1. 19/08/2014, Ian Clark wrote

    David, you said “Last week, I said that the stock market’s main purpose was to connect those of us who have savings to invest with companies who need risk capital to fund their operations.”

    Providing finance for companies only accounts for about 1% or 2% of stock market activity. 98%+ of activity is simply trading in existing shares, yielding little benefit to the companies, only to the investors, whether buyers or sellers. Trading is a zero-sum game, that provides little net benefit to the wider economy, with one investor’s profit another’s loss.

  2. 20/08/2014, Clive wrote

    @ Ian Clark

    but, how many people would invest in shares if there wasn’t a secondary market where you could sell shares ?

  3. 21/08/2014, AndyA wrote

    There is also the point that if investors think the shares are a buy then share price goes up (or at least doesn’t go down) which helps the company’s credibility and to do business etc.

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