The recent trend of de-equitisation, where the amount of equity circulating around the market shrinks, could result in both good and bad outcomes for investors depending on their positioning in the market.
A cursory glance at the UK’s equity landscape is enough to realise that there has been a marked slowdown in the number of new companies coming to market in recent months, with only three firms making their initial public offerings (IPOs) in London during the first quarter of 2019 according to industry data firm Dealogic, the lowest number in a decade.
The number of total companies listed on the London Stock Exchange (LSE) is also in decline, with the main board of the exchange having seen a net loss of 318 companies over the last decade as of April 2019.
AIM, meanwhile, has seen a slightly sharper loss of 389 firms over the same period; however, while the equity pipeline is fairly dry at the moment, the market is also having to contend with more and more of the supply being siphoned off through share buybacks, acquisitions and de-listings, usually undertaken by larger companies with monetary clout that few new listings can make up for.
For example, the FTSE 100 owner of Premier Inn, Whitbread plc (LON:WTB), is currently undertaking a £2.5bn share buyback after selling its Costa Coffee chain to soft drinks giant Coca Cola Co (NYSE:KO) for around £4.02bn (US$5.1bn) in January.
There have also been several high-profile collapses including department store chain Debenhams and outsourcing firm Interserve, effectively wiping out the equity of both.
Meanwhile, the merger and acquisitions front has seen FTSE 250 satellite operator Inmarsat agree to a £2.7bn takeover deal from two private equity firms and plastics maker and fellow mid-cap RPC agreeing to a £3.34bn takeover by US rival Berry Global.
Added together, that’s more than £8.5bn in equity being removed from the market, more than ten times the combined £445.2mln market capitalisation of the three companies that IPO’d in the first quarter.
A reversal of the trend also seems unlikely, with ultra-low interest rates meaning it is often cheaper for a company to take on debt to finance its activities rather than tap the market for capital.
Escaping de-equitisation by shifting funds to foreign markets won’t help either, with data from the World Bank showing that the number of listed companies worldwide is currently undergoing a general shrinkage, having fallen from 43,872 in 2008 to about 42,099 in 2018, a drop of around 4%.
This all sounds like a fairly grim future of sparse investment opportunities but the shrinking equity pool could be good news for some investors.
Share buybacks, for example, have the (somewhat obvious) benefit of increasing the percentage each investor owns in a company, thereby giving them a greater share of the profits when the firm does well, while also (as per the laws of supply and demand) supporting the share price.
Takeover offers, or even rumours of such, can also provide a boost to shares, and with global private equity funds currently sitting on a record amount of around US$2 trillion in uncalled capital as of 2018, the funds are likely to look for more opportunities to spend their cash, and will have more firepower for offers.
“If the supply is shrinking and you still have plentiful liquidity…in theory, the technicals would suggest that demand is higher than supply, which would be a good thing”, says Russ Mould, investment director at AJ Bell.
He adds that with central banks recently keeping interest rates low, companies are unsure about the “real cost of capital” and are therefore not willing to risk taking on major projects when they could simply buy back their stock and goose their earnings per share (EPS) that way.
“It’s a cynical way of looking at it but in terms of providing relatively risk-free shareholder value in the short-term it’s quite hard to argue with”, Mould said
However, he also warns that while the recent trend of de-equitisation and share buybacks has been supporting the market, these tend to be “pro-cyclical” with the cost of debt; once the cost of borrowing goes up the activity will likely grind to a halt, adding that that if a company spends most of its time using its funds to boost EPS, it may be leaving itself weaker in the longer-term as it will not have invested in its competitive position while also taking on more debt.
“[Buying back shares] looks smart when interest rates are at record lows…but it looks a lot less smart if borrowing costs ever go up”, Mould said.
Although with the market currently pricing in as many as two Federal Reserve interest cuts this year, borrowing costs, and therefore the de-equitisation trend, seems set to continue for some time yet.