What does Dickens’ A Tale of Two Cities and the average FTSE 100 annual investor relations report have in common?
While you mull over that, let’s have a quick recap of the rather Dickensian state of the London Stock Exchange this year.
On the IPO front, very little has happened with just 18 new London listings conducted across all segments of the LSE.
The London Stock Exchange Group PLC (LSE:LSEG) would have you believe the first six months were actually pretty good for the City. But rudimentary analysis of LSEG’s own data showing £11 billion in funds raised was flattered by non-dilutive cross trades and follow-ons.
In reality, just £400 million was raised through IPOs in the first six months, compared to something closer to £7 billion in 2019.
If you’ve had your eye on the markets, none of this will be coming as a surprise to you.
In fact, the UK stock exchanges have witnessed a consistent drop in the number of listed companies over the past two decades, from a zenith of 3,273 firms in 2007 to less than 2,000 today. In other words, at least a 39% decline.
If only it was separating the wheat from the chaff, but as we have seen in 2023, that simply isn’t the case.
ARM Holdings’ high-profile decision to snub its English homeland for the greener grass of New York should be enough to drive that point home, but if more convincing is needed, here are some other firms preparing to, or at least considering, a flight across the Atlantic:
- Construction firm CRH - the £32 billion market cap group
- Gambling company Flutter Entertainment - £24.6 billion market cap
- Insulation group Kingspan - £11.6 billion market cap
- Trading platform Plus500 - £1.17 billion market cap
- Analytics company YouGov - £1.06 billion market cap
And this is not even touching on the flurry of small caps confirming their London delisting plans, including brokerage Numis Corporation (which is being bought out by Deutsche Bank no less), energy group Solgenics, Applied Graphene Materials and more.
To be fair to the Square Mile, global capital markets trends have pointed to a concentration in aggregate market capitalisation to fewer and fewer firms over time, owing to the rise of private equity and consolidation.
Far from a UK trend, the number of public-company listings in the US in 2021 was nearly half of the mid-1990s peak.
But if these are global trends, why has the transatlantic valuation gap widened so much?
UK valuations at Arm’s length
Depending on who you ask, a decent company can get anywhere between a 30% and a meaty 107% premium on its valuation by opting to go public in New York over London (particularly if you’re a tech company).
There is a distinct lack of research on the transatlantic valuation gap, and it varies greatly from sector to sector, making a precise figure difficult to pinpoint.
But a broad brush analysis is anything but ambiguous.
On a trailing 12-month basis, the US Russel 2000 small-cap index has a 32-times price-to-earnings ratio, while to Nasdaq blue-chip index has a 30-times PE ratio. The broader S&P 500 index has a 20-times PE ratio.
On a forward 12-month estimation, Russell 2000’s PE ratio is 24.75, Nasdaq 27.5 and the S&P 500 20 times, per Wall Street Journal analysis.
In the UK, the FTSE 350 PE ratio currently sits at around 14.5 times, with the blue-chip FTSE 100 index sitting at just 10.7-time price to earnings.
UK politicians were desperate to keep Arm’s IPO local. But given Arm’s potential US$70 billion valuation would be reduced to less than US$30 billion if taking these blue-chip PE ratios at face value, calling it a hard sell is an understatement.
Forward guidance on UK valuations are harder to come by, but analysts agree that the gap is steadily widening.
For Matt Goode, head of consumer at finnCap Capital Markets, it’s no mystery why.
In plain terms, “the pool of liquidity in the US is bigger”. This makes perfect sense, given 58% of global equity capital is concentrated in the US, but there is more nuance to the problem.
Goode noted that, with the drift away from defined benefit (DB) schemes (aka final salary pensions) towards defined contribution (DC), UK pension funds have considerably lower risk appetites than they used to.
“And therefore, the bond markets have grown hugely relative to equities,” noted Goode.
There is data to back this up. According to Schroders, the average bond allocation in a DB pension fund surged from approximately 20% in 1996 to 50% by 2012, and stood at 63% in 2022.
Though DBs are on the decline, they are still a powerful force in the UK investment scene, with around £1.5 trillion in assets under management.
So it’s sobering to hear that DBs had around 71% of their assets tied up in UK equities in 1996. Today, that figure is closer to 10%. Clearly, this has significantly impacted domestic pools of capital.
Goode noted that the recently announced commitment from UK pension funds to commit 5% of funds under management to unlisted equities (including AIM securities) is a step in the right direction, however.
The risk of risk aversion
According to Goode, there are cultural differences between investors in the UK and the US.
“There is a broader culture of investing in equities in the States,” said Goode. “That has always driven a bit more interest in equities from retail investors in the US, but that has always been there.”
Regardless, Goode contended that over the past 15 to 20 years, the allocations of fund managers towards UK equities are definitely smaller proportionally than they used to be.
Is it really as surface level as that, or are there deeper societal undercurrents in the US pulling liquidity across the pond?
“I think there’s a broader (US) culture, societally, which is to take a risk and don't shoot people down if people don't get it right every time.
“The number of stories you hear of people who've had business failures in the US, but then have gone again and been successful… That side of things in the US, the ‘have-a-go’ culture and the relative lack of societal judgement on failure are important factors.”
This at least explains how WeWork founder Adam Neumann managed to convince Andreessen Horowitz to give him another US$350 million a few years after tanking the co-working giant’s IPO.
From how Goode talks, it’s as if Britain’s aversion to risk turned out to be the biggest risk of all.
Small caps feel the pinch
To use a tired cliche, if London wants to grow the mighty oaks of tomorrow’s stock market, then today’s saplings need somewhere to thrive.
Unfortunately, the City seem to be lacking a green thumb these days.
It is true that London’s junior AIM market has cultivated a handful of household names over the years, including ASOS and Domino's Pizza.
Many less captivating – yet still successful – mid-caps have branched out into the main market since the growth engine launched in 1995.
But when you see how the US gave the space for global giants like Amazon, Nvidia and Netflix to blossom from relatively humble beginnings, it becomes clear that something is holding London’s blue chips of tomorrow back.
In its most recent ‘State of the Small and Mid-cap Sector’ research report, the Quoted Companies Alliance (QCA) explained how listed companies at the lower end of the market are being hampered by bureaucracy.
According to the QCA research report, the average FTSE 100 annual financial report now exceeds 140,000 words, matching that of Dickens’ tale of French Revolution.
Companies with fewer resources are even more burdened. An analysis of AIM constituents valued under £250 million revealed that reports have expanded by 51% over five years, adding an average of 3,000 words or six pages annually.
In fact, the average FTSE 100 report as of 2022 was as much as 147,000 words, and is growing by around 8,400 words, or nearly nine pages, every year.
It truly is the worst of times to be working in a plc’s accounts department.
Flippant though this fact may sound, it speaks to a wider issue plaguing UK plcs.
Oppressive regulatory overreach, made worse by rigorous ESG reporting requirements, have added another layer of expense for companies, many with limited resources, wanting to list on AIM.
“The time-consuming and costly processes involved in producing a prospectus are a significant and disproportionate burden for small and mid-sized quoted companies,” said the QCA.
Add in the usual underwriting and brokerage fees, and many small to mid caps simply cannot take on the expense of a public listing.
The government’s UK Prospectus Regime Review took steps to alleviate this financial burden by delegating a greater degree of responsibility to the Financial Conduct Authority (FCA), though the QCA is calling for further liberalisation on this front.
Somewhat antithetical to quoted companies’ oversized reporting burdens is the fact that the quality of research on these companies is in decline.
This appears to be an unintended result of EU-era MiFID II legislation that increased the oversight of data reporting service providers.
Independent research is a key component of thriving capital markets. The QCA went as far as to say that “research eases price discovery and enhances liquidity, which in turn reduces the cost of capital for companies and encourages their growth”.
No more pronounced is this dearth of financial research than in the technology and innovation sectors. Investment banks often cite this as a major advantage the US has over the UK.
Unfortunately, these investment banks are the very institutions with the requisite resources to address this imbalance.
“This is a chicken and egg situation, but government and market operators must find a way to crack this impediment through soft politics, incentives and other measures,” said the QCA.
Regulatory burdens are far from a British problem, but have nonetheless compounded the City’s struggle with staying internationally relevant.
No wonder Arm has snubbed London.