Has the Canadian Small-Cap Market Become a Victim of Over-regulation?

Joel Anderson  |

The Canadian economy is facing a serious danger, one that operates in the margins, relatively well hidden from those who wouldn’t know to look for it. It’s a danger that has the chance to restrict growth for companies, workers, and investors alike.

That danger is the slow, choking death of the country’s emerging growth firms through onerous and excessive regulation.

This isn’t something that’s immediately apparent to people not working close to the stock markets, but it has far-ranging consequences, nonetheless. Emerging growth companies are frequently small in size, lacking the sort of broad visibility of their large-cap counterparts. However, in almost any economy, it’s the emerging growth companies that are driving innovation and job growth.

And that’s all the more true in Canada, where the vast majority of domestic companies are in the category of emerging growth. This issue is one that threatens the very nature of the Canadian economy, slowly killing a vibrant, diverse ecosystem of emerging growth companies in favor of placing economic power in the hands of a few major players.

The Right Regulations, the Wrong Size

The regulations in question are well-meaning ones. They’re designed to protect investors from bad players and make it difficult to commit fraud. Any public company has a number of reporting responsibilities. They must report their financial information four times a year, as well as supplying cautious predictions about future earnings and growth.

However, depending on the nature and scope of this reporting, it can quickly become exceedingly difficult to manage. Independent audits and reporting can be very costly, requiring large sums of money to be spent year after year to ensure the books are being kept honestly.

And it’s certainly not true that these regulations serve no purpose. Any company committing fraud or trying to create short-term stock gains through accounting gimmicks hurts investors and employees alike. That issue gets even bigger when you consider the systemic risk posed by larger companies acting in these ways.

The prime example comes from the United States, where the very public collapse of companies like WorldCom and Enron were utterly disastrous. Those large-cap companies were the sort of stocks held by mutual and pension funds. Average investors saving for their retirement were hit hard, finding that they were exposed to a level of risk that they never would have willingly taken on had they been privy to the extent of the situation.

For companies like these, there’s a serious systemic risk associated with their collapse. Given that the entire economy can potentially be thrown into a tailspin by the wrong firm erecting a house of cards through tricky accounting, it’s important that such companies be closely watched and required to submit to independent audits while diligently reporting results to the general public.

Overprotective Regulations the May Strangle Growth

However, for emerging growth companies, that systemic risk simply doesn’t exist. Certainly, the dangers of fraud or malfeasance are very real for individual investors, but emerging growth companies aren’t included in the sort of low-risk mutual funds that most people are counting on for their retirement. For the most part, anyone investing in these companies is making a conscious choice to do so. These are also companies that are much more numerous. The collapse of any one is problematic, but it’s also a disaster that’s limited to the company and its investors, rarely, if ever rippling out through the rest of the equities markets or the broader economy.

What’s more, for smaller companies, the financial burdens of meeting these regulatory requirements can be considerable. Emerging growth companies are being forced to keep their books at large-cap prices, and it’s crippling their ability to do business.

Don Mosher is one of the founders of B&D Capital, a Vancouver-based research and investing firm, and he has 25 years of experience in Canadian equities markets. Don’s closeness to these markets makes him aware of just how difficult this regulatory regime can be for companies that are already struggling to grow.

“Regulations are essential to credible markets, but there needs to be less costly, simpler regulations for small- and nano-cap companies and the brokers that support them,” says Mosher. “[For these companies], 60% to 70% of top line revenue goes to regulatory costs. No business can survive those costs unless the firm is large and diverse enough, like our big six banks that all qualify as large-cap companies. The banks have no interest in the venture business, with the exception of the successful companies that move to their level. The banks only want to manage wealth - not create it - and sell their proprietary products to as large of a percentage of the Canadian population as possible without any regard for the future health of the Canadian economy.”

Job Creation Strangled When Smaller Companies are Pushed Out

And the future health of the Canadian economy should, in fact, be a major concern. The sort of large-cap companies that the banks are catering to actually do very little to drive innovation or create jobs. As often as not, the size of their market share is largely defined by the time a company reaches that size. There may be some fluctuation in payroll numbers, but there are rarely, if ever, net job gains in the long term. Job gains in one area are usually offset by losses elsewhere.

Emerging growth companies, though, are driving real economic growth through innovation. These firms are actually building something new, not simply maintaining the gains of years or decades past. That means the money these firms are spending on onerous accounting requirements is money they’re not spending developing new products and hiring new employees. The role played by these emerging growth companies in the Canadian economy is to be the primary, if not the only, driver of job creation.

“Imbalance is the problem,” Mosher continues. “My analogy is letting personal injury lawyers regulate transportation. People are maimed and killed on a daily basis, but the health of the industry is always taken into account. The highways are not shut down after an accident; cause is studied, and solutions proposed, whether policing, speed limits, or perhaps re-engineering an intersection. This process allows for the movement of goods while helping prevent future accidents. Infractions are sent to the courts for judgement, not kept within a regulatory regime that has made the regulations too complicated for the police and courts.”

An Equities Market Driven by its Diversity

The issues for small-cap companies are serious on both sides of the border. In the United States, emerging growth companies are currently struggling under the Sarbanes-Oxley Act, a 2002 bill passed in reaction to the Enron scandal that created much of the current regulatory structure that’s making it so expensive to function as a public company.

However, the problem is much more acute in Canada for one simple reason: the portion of the Canadian market that qualifies as emerging growth is much larger than it is in the United States.

“Canada is, for the most part, small business by the US definition,” says Mosher. “We have the population of California, but spread across the second largest country by land mass in the world. … The total number of publically traded companies on the TSX and TSXV Exchange is 3,486 companies. Small-cap companies are defined in the US as under $2 billion US [in market cap], only 139 publically traded companies in Canada exceed that threshold. Forty-one TSX companies would qualify as large-cap, meaning over $10 billion US. Most of our listings would be categorized as nano-cap, defined as a market cap of under $50 million US.”

On the whole, a regulatory atmosphere that’s a problem in the United States is arguably a disaster in Canada, where the vast majority of the market’s players fall outside of those companies whose size allows them to absorb the costs of being a public company. The result is an increasing concentration of economic power in the hands of companies and banks that represent a small slice of the total market.

Especially when you consider the fact that it’s success in the Venture Exchange that often helps drive success at higher levels, something detailed in a Toronto Venture Exchange (TXSV) whitepaper from this last December. Some 614 companies have graduated from the TXSV to the Toronto Stock Exchange (TSX), making up almost 20% of the S&P/TSX Composite Index and 1 in 10 TSX-listed companies with a market cap of $1 billion of more, and have raised more than $100 billion in public equity capital.

If today’s emerging growth companies are getting choked to death in their infancy, it could mean that promising big firms of the future are dying before ever even getting off the ground.

Lack of Choice Ultimately Costs Investors

This is a broader issue than the emerging growth companies finding themselves drowning in regulation, or even the Canadian economy robbed of its primary driver of job creation. It’s also robbing investors of the opportunity to have a diverse range of options for their own portfolios.

On the one hand, protecting investors from bad players, or even good ones that are simply not ready for investment, is important to creating a public market that’s truly safe for the public. However, depriving investors of the chance to knowingly take calculated risks in pursuit of better returns can be just as harmful as failing to root out those companies that might exploit them.

What’s more, creating an atmosphere so hostile to emerging growth companies also drives away those brokerage and research firms that might otherwise provide investors with the insight and knowledge they need to make informed decisions. Emerging growth companies involve a lot more risk and a lot more potential returns than their large-cap counterparts, meaning it’s essential for investors to get help in sifting through thousands of different options. And yet, with the perverse financial incentives created by this difficult regulatory environment, the firms that need research the least are the ones that get it, while those that need it the most are left out in the cold.

“The resulting consolidation of the Canadian Financial Industry results in fewer options being available to the investment public,” Mosher laments. “Without the boutiques brokerage firms, there is no coverage or corporate finance for the small- and nano-cap companies. Every investor will be forced into proprietary products produced by a few firms that, in Canada, only have to sell their own products. One of the reason ETFs have become so popular is the argument that diversification will reduce risk, conversely the fewer investment firms all selling similar products must increase the risk of a major failure in the Canadian Markets.”

On the whole, the ecosystem is one that’s driving out the smaller players so essential to a healthy equities market.

“In Vancouver, there were about forty Boutique brokerage Firms,” says Mosher. “Now we have seven.”

It’s an issue that’s compounded by a similar problem with the local media. Despite the fact that Canada is a country with an economy largely defined by small-, micro-, and nano-cap companies, and larger companies that had to work their way up from that level, those very companies cannot seem to get the sort of media coverage they need to spark interest among investors.

It’s hard to say what might happen if the sort of companies trading on the Venture Exchange could get the same level of attention from media and research firms as they did from regulators, but suffice to say even more of the TSX might be made up of TSXV graduates.

Right-Sized Regulations a Key to Creating a Prosperous Future

The emerging growth market in Canada should be something that Canadian securities law is working to cultivate, not destroy. There is certainly a lot of risk involved in the space, but a legal regime that seems primarily committed to protecting investors from these companies is a sign of a fundamental disconnect.

Risk is inherently present in investment. But the idea that investors can’t be expected to make decisions about their own portfolios without the protection of securities regulators at every turn is one that can have dangerous consequences for the Canadian equities markets and the economy as a whole. What’s more, a simple right-sizing of regulations can give emerging growth companies the chance to invest in their future, create jobs, and build themselves up.

This particular issue is one that can frequently be overlooked by anyone not directly associated with these markets. But just because these companies are smaller does not make them any less essential. And simply allowing them to slowly fade away will have broader consequences than people realize. A healthy equities market that bolsters all players rather than simply focusing power and capital in the hands of the few is one that’s best for all Canadians.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer



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