Indexation, passive investing, computer-driven trading or tracker funds. Whatever the jargon, there is a clear, growing and global trend toward institutional investment in the small number of very large companies which make up the main stock indices. The result is massive price distortion, with big company shares attracting huge sums of investors’ money while, at the other end of the scale, good but smaller companies are struggling to be noticed by the large, influential funds. It all poses a serious investor relations challenge for smaller companies.
The problem is particularly acute in Europe at the moment where asset allocation and stock selection are being re-jigged in the wake of the introduction of the euro. The impact is not just confined to the eurozone. Half the market capitalization of London’s FTSE 100 index is now represented by only 13 companies. In fact, just six companies now account for 30 percent of London’s entire market cap. Research carried out by ABN Amro in the run up to the launch of the euro among 55 major investment institutions showed that one-third of respondents expected to move to a European benchmark index. Over four-fifths said this would take less than a year to complete. The Dutch bank also showed that only 27 companies were common to the five major benchmark indices (see Investor Relations, June 1999).
All indicators point to burgeoning institutional demand for the major stocks whether or not investors buy indexed products or individual stocks. The result is that some major companies are trading at P/E ratios of 40 as compared to single digit P/Es for the smaller cap stocks that languish outside the main indices. Many institutions have started to talk about small cap as being anything under the £1 bn market cap mark.
A dubiously virtuous circle has evolved as research by those cash-friendly investors at Phillips & Drew has shown (Indexation and the large-cap effect, February 1999). Spurred on by a so-called flight to quality following last year’s collapse of Long Term Capital Management and the Russian crisis, institutions have invested heavily in the major players in sectors such as financials, oils, pharmaceuticals, telecoms and technology. Prices have risen and investor returns have encouraged further demand for major stocks from both active and passive fund managers.
‘From a minority activity, and indexation as a minority activity seems to us perfectly sensible,’ intones Phillips & Drew, ‘indexation has rapidly become the fastest growing equity investment strategy. Mimicking the market’s investment strategy has become an established and institutionalized practice.’
Driving up stock values in defiance of underlying company efficiencies and profitability cannot last forever. Phillips & Drew speculates that the chickens could come home to roost. ‘The unwinding process could be started by a sustained bear market, the transition to indexation coming to an end or the intrusion of the real world in terms of profit disappointments.’
The timing of such a reversal is something fund managers, individuals and companies themselves would dearly like to be able to call. And such a turning tide could bring benefits for the capital-parched small-cap sector.
Smaller companies have been out of favor for some time, as Anthony Ashton head of Bacon & Woodrow’s international investment consulting practice explains. ‘The larger funds do notice the need for small companies to attract investment funds. But as far as the FTSE All-share is concerned, only something like 5 per cent of the market capitalization of the index is taken up by stocks outside the top 300. If a typical institutional investor makes a strategic decision to, say, gain exposure to UK equities, they will naturally concentrate most of their time and resources into the 95 per cent. In other words the larger cap stocks.’
But with smaller cap stocks now substantially undervalued it wouldn’t take much of a shift of strategy by the big fund managers, according to Phillips & Drew, to make the sector ‘fashionably expensive.’ And maybe the green shoots of such change are starting to appear.
Bid fever
Merrill Lynch has estimated that about 10 per cent of London’s Small Cap index members have experienced recent ‘corporate activity’, that is bid approaches. It says a further 13 per cent have been the subject of bid speculation. One reason for this could be the need for smaller companies to achieve critical mass sufficient for them to cross the jump into the next size bracket.
While agreeing to be taken over or absorbed may seem a self-destructive way to attract investment, if the aim of the game is to increase shareholder value, that is to say share price, then small company directors may choose this route.
Another route is de-listing from the stock market altogether. Buy-out and venture capital funds are currently awash with cash with which to buy companies with a view to restructuring or repackaging them and eventually exiting a trade sale or a new flotation.
In a recent study, pan-European accountants Mazars Neville Russell found that 87 percent of companies listed on London’s Alternative Investment Market believe there is not enough liquidity in their market to encourage investors. Mazars’ head of corporate finance Philip Chamberlain says, ‘Small companies have to decide what they want from being listed on a market in the first place. Then they can decide whether Aim or a European market is best for them. Or indeed a private placing of capital. But they have to look really seriously at everything available in a structured way. What is right for some companies may not be right for others.’
The message is clear. Perhaps traditional stock markets are not the place that brings best benefits to small companies in terms of access to and price of capital. Chamberlain recommends that companies look seriously at Euro.NM, the small company market grouping which is gradually becoming truly pan-European as more markets join forces with Germany’s Neuer Markt and France’s Nouveau Marche. Easdaq provides another option.
‘We are not yet at a point where investors compare small companies across Europe,’ concedes Chamberlain. ‘But I would say we are getting there. There have certainly been great strides made in the past twelve months. There appears to be more appetite for smaller listed companies in [continental] Europe. Certainly there is appetite among UK companies for [continental] European capital.’
For smaller and especially fledgling companies an efficient Europe-wide growth company market may fit the bill. This poses radical investor relations questions requiring careful analysis of a small companies’ investment needs and options. And that takes resources.
The first issue is whether or not the current market is enabling smaller companies to grow at the required rate. Is there liquidity in the stock? Is it too much of an uphill struggle to gain notice from unwilling institutional investors? Where, in other words, is the investor base? And is it equity capital that is required? As debt markets become deeper and cheaper perhaps this is a better option.
But before disenchantment with stock markets sets in it is worth bearing in mind that some of the world’s largest companies by market cap today are those which hardly existed a relatively short time ago, Microsoft and Intel among them. But they did have extraordinary products, brilliant timing and willing investors on their side… and either great skill or good fortune in investor relations.
As the Financial Times noted on May 6 this year: ‘The market capitalization of Charles Schwab, the online broker, recently exceeded Merrill Lynch’s and between 1975 and 1995 60 per cent of the companies on the Fortune 500 were replaced.’ The article goes on to note that the new entrants to the list ‘either created markets or recreated existing ones.’
It may be doom and gloom at the moment for smaller companies but Phillips & Drew detects some light at the end of the tunnel. It sees weakness inherent in the current trend toward indexation, in the so-called large-cap effect and in the over reliance on market cap as the determinant of individual stock weightings. ‘Perhaps,’ says its report, ‘the only truism is that the more people follow a strategy the more likely it is to fail and index tracking in its many guises is high fashion at the moment.’
Fragment ahead
The last word might best go to a small company entrepreneur whose vision is of a new industrial infrastructure which will call for a radical rethink in investment habits. Mark Dixon, who established Regus, the rented offices business which now operates in more than 40 countries, says: ‘In five or ten years time the UK economy won’t be made up of 100 or 200 very large companies but by thousands of small ones. There is going to be continuing fragmentation. It’s already happening in America and it’s going to happen worldwide. You will have many more entrepreneurs and you have much more of a virtual society ahead. It is the small businesses which will be the bedrock of the future.’
If he is right then swift-footed investor relations techniques will be required, to leverage flexible investment to match fast-moving small company development. Looking back, indexation and the global industrial consolidation of the late 1990s may then look like the final coupling of dinosaurs; ultimately unproductive and based upon false premises. Whether this will prove to be true remains to be seen. Many are now saying that the market cannot sustain current pricing levels driven ever upward by indexation and the large-cap effect, so maybe, at last, it is the small caps’ turn to shine.
