The Philanthropy of the Uninformed:
The Better It Gets, The Worse It Gets

It’s no secret that I’m an incorrigible optimist. When I look at the broad sweep of the human saga, I’m overwhelmed by history’s generosity—two hundred years of ever-increasing Western prosperity born on a continuous stream of technological progress. Only those untutored in the squalor of the pre-modern world would deny that the quality of life, morals, social justice, and even political discourse has improved immeasurably over the decades and centuries. For those libertarian romantics who’ve saved up for a time journey back to the late-nineteenth century Valhalla of perfect Anglo-American capitalism, I have some advice: don’t forget your antibiotics, antiemetics, nose plugs, and Mace.

Likewise, to posit that the fruits of market capitalism benefit mainly the capitalists and not the common man is to betray an inexcusable ignorance of basic economics. In the past century, the portion of GDP accruing to labor, capital, and land has remained reasonably close to the 80/10/10 ratio obtained ever since such data first became available. Manifestly, the major beneficiary of the system is the working class.

Contrary to popular expectation, the fruits of capitalism are slowly being prised from the capitalists’ greedy fingers. I am speaking, of course, in the broad historical sense. Consider that the first recorded loans in Sumeria paid interest of 20% on silver and 33% on grain. While these high rates certainly carried with them risk of default and confiscation, there can be no doubt that life was good for the first few Sumerian protocaptialists, that is, those who actually had excess silver and grain to loan.

Likewise, the first English joint stock companies paid their investors quite handsomely. In its first several decades at the start of the seventeenth century, the East India Company (EIC) could not even attract permanent capital—each voyage was separately funded, the investors completely paid off by the precious contents of the flotilla as it returned up the Thames eighteen months later. Consummate with the highly risky nature of the enterprise, returns were usually well north of 100%.

Not until the EIC proved that it could reliably deliver the goods did shareholders permanently surrender their capital in return for an annual low double-digit dividend. By the turn of the nineteenth century, the Crown could sell consols (perpetual bonds) at slightly more than two percent. (Hence Bagehot’s famous dictum: "John Bull can bear many things, but he cannot bear two percent." That is, low rates encouraged imprudent speculation on chancy enterprises. Plus ça change.)

In Britain, the U.S., and the rest of the world, prudent investors were wary of common stocks, and equity capital remained harder to come by. No more. In recent years, the expected return on equity has plummeted around the globe. Existing companies—"seasoned issues"—yield less than 2%, and even the best case scenario has their per-share dividends and earnings growing only slightly more rapidly than inflation. (I’ve italicized "per share" for a reason. The best evidence is that in the U.S., companies dilute their outstanding shares by about 2% per year; this factor must be subtracted from the growth of aggregate GDP and corporate earnings and dividends.) Of course, strictly speaking, when you buy a seasoned issue, you’re not investing; you’re merely saving. In the economic sense, you get a gold star only by providing capital directly to a company, either through an IPO (initial public offering) or to an existing firm in the form of a secondary issue.

In a recent working paper, Fama and French examined the survival and profitability of new issues. Their results were eye-opening. Between 1973 and 2001, the number of IPOs increased dramatically, from around 160 per year to about 550 per year. Their profitability decreased (in the words of the authors, became "left skewed") as did their survivorship, while their growth became "right skewed." Growth, on average, decreased slightly, though a few highly successful companies saw dramatic growth.

In 1973, the probability of an IPO going kerplunk within ten years was only one in six. Just a decade later, the chances rocketed to two in five. Four hundred years ago, one might have recoiled from the financial risk of outfitting ships for the Indies. (To say nothing of the physical risks; the mortality on such journeys hovered around 50%. "Hell on earth" is not too strong a descriptor to be taken from sailor’s diaries. The term "ghost ship" derives from the point reached by many vessels when enough of the crew died and the survivors became so debilitated that they could no longer control the ship, which, as it drifted aimlessly across the maritime lanes, became a slowly moving death trap for the remaining crew.)

However, the Fama-French data suggest that, at least in terms of financial risk, supplying capital to new enterprises hasn’t become any less dangerous. In fact, compared to the business models of most 1990s dot-com startups, sending an illiterate, poorly nourished crew on a 25,000-mile round-trip journey in tiny rickety boats through stormy and hostile seas was a lead-pipe cinch.

While not a boon to modern investors, the facile market for new equity capital has been great for the rest of society. Someone, after all, had to capitalize all the wonderful new technologies that have given birth to the modern world: in the eighteenth and early nineteenth centuries, the fabulously expensive canals; later in the nineteenth century, the railroads; and in the twentieth century, steel, radio, autos, utilities, and aircraft. On average, investors in these companies got their clocks cleaned. The same, of course, will prove true of those generous souls who capitalized the vast fiber networks, biotech outfits, and hardware and software startups that will remake humankind in the coming century.

Far from being the play’s villain, modern capitalists have become our society’s great philanthropists, tossing great wads of money out their figurative windows so that the rest of us may prosper. (Since their philanthropic behavior is not intentional, they do not garner the maximum brownie points.) A superb example is the recent reliance of public finance on state lotteries—the quintessential tax on the uninformed. What Fama and French’s data are telling us is that the bar to companies seeking entrepreneurial capital has been lowered yet further; entrepreneurial capitalism has advanced to the point that if you are a twenty-something with a cockamamie idea that might, just might, pay off, you will be buried in seed money. (This is not to sneer at greedy young people; human genius is most productive in early adulthood, and one of the unrecognized advantages of the American system is that we allow our youth to sass their elders and do not beat the creativity out of our best and brightest by making them master three languages and stochastic calculus by age sixteen.)

Clearly, then, IPO investing, while not having gotten riskier in the past several decades, has become a higher-stakes game—the payoff may not have changed, but the stakes are higher and the probability of success lower on each throw of the dice. What of their expected returns? This is a tad more controversial. While initial work by Jay Ritter and others demonstrated new-issue returns that were several percent lower than that of the market, more recent work by Fama and French suggests that IPO returns are commensurate with their size and value loadings. And since the value loadings of these issues are strongly negative, their returns are lower than that of the broad market—a rose by any other name. An even more interesting question concerns the risks and returns of IPOs; it is difficult to argue, as the three-factor model does, that efficient markets demand that they offer lower raw returns because they are somehow less risky.

The situation with IPOs mirrors the situation in the broader market documented by Burton Malkiel and his colleagues—higher volatility in individual names counterbalanced by decreasing correlations among them. While overall market volatility remains unchanged, a larger portfolio is required to obtain adequate diversification. The most recent Fama-French data show that IPOs have become even more like lottery tickets; it has never been easier, by concentrating on just a few issues, to become fabulously wealthy. And it has never been easier, by regularly throwing money at them, to become poor.

As our society becomes ever wealthier and the return to capitalists falls ever lower, let us raise our glasses and toast the system’s great unwitting philanthropists, whose generosity funds the pullulating mass of ever riskier young companies, a few of which will eventually pay off big and power our economy.

Copyright © 2004, William J. Bernstein. All rights reserved.

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