A Thought on Capital Market Power, Risk, Small Caps, and Large Caps

A few days ago I tweeted a question about whether a theory that less expensive stock trading contributed to fewer IPO’s holds water. The theory is that cheaper trading results in less revenue to fund analyst coverage of companies hoping to go public in the $50 million — $100 million range. In the 90s, a relatively small number of such companies — big names today — created hundreds of thousands of new jobs after going public, so there is certainly precedent that doing so can be a very good thing.

Tonight, after reading a post by Miles Jenning (publisher of http://www.ownershipview.com/) in the LinkedIn XBRL Interactive Network, I had a thought. (The topic of Miles’ post was a law professor’s blog on the use of technology to address the crisis. See http://www.theconglomerate.org/2009/11/if-complexity-is-the-problem-is-technology-the-cure.html — worth the read.) Before the current financial crisis, investors could look at history and see that “safe” investing in larger, more stable,

less risky companies gave them pretty decent returns over time. This was particularly true in light of the disparity between NYSE and Nasdaq performance as a result of the dot com boom.

Now, however, much of the commentary isn’t so confident about long term big cap performance. There seems to be more advice that if you’re going to trade stocks, you need to pay closer attention to your companies and not put faith in long term historical trends. In other words, investors are being told there’s more risk in big cap than you realized.

So here’s the thought: If big cap companies are perceived as riskier, will that perception reduce the appetite of investors for big cap stocks relative to small cap stocks, which investors have always known were relatively risky? (You might buy 10 small caps in the hope that one will make it big, but even that seems riskier than simply buying GE — at least it did before the crisis.) In other words, will new perceptions that big cap stocks are riskier drive people back toward smaller new issues simply because the relative risk of small caps seems smaller than it was before the pre-crisis? And will that in turn mitigate the trend of fewer smaller cap IPO’s over the past decade by increasing market demand for small caps and therefore IPO valuations?

If relative risk has that sort of impact, perhaps a self-correcting mechanism in the form of changing market preferences based on changing views of risk is possible. That is not to say that other steps couldn’t help improve the allocation of capital toward job-producing forward-looking growth companies. Goodness knows, policies that would free business of all sizes to create more jobs are a dime a dozen. It’s the execution of any of those policies that’s stuck in gridlock. But it is to say that markets find funny ways of getting around obstacles — whether those obstacles are imaginary, perceived, theoretical, or real. Might changes in risk perception be a path toward economic recovery?