Why private markets are a bigger threat to the London Stock Exchange than New York

Given how much time has been spent pondering the declining fortunes of the UK stock market, it is remarkable how much confusion there is about the basic facts.

For example, it has become accepted that after a long period of lagging performance, the UK equity market is trading at a big discount to New York, making it hard for London to attract new companies and even to retain the ones it has. Yet it is not clear if this is true.

Comparing the valuations of stock markets is tricky, not least because they tend to have a very different mix of sectors that have relative ups and downs. The UK market is much more heavily weighted towards financial and energy companies, while the surge in the stock prices of the half-dozen top US tech companies accounts for about 40% of the rise in the S&P 500 index over the past six years.

Brexit blues

In any case, when a company’s owners are mulling where to float, what matters most is not the market valuation but how similar companies are valued. Here the evidence does not fit the narrative.

UBS looked at 60 sectors and compared the valuation of the most relevant companies: BT against Verizon; WPP against Omnicom; BP against ExxonMobil; and so on. It found that the UK companies’ valuations were either in line with or better than those of their US counterparts in about 40% of cases.

So while the UK and European markets may trade at a modest discount to the US, relative valuation of individual stocks should not be nearly as big a problem for London as is widely assumed.

What makes this more surprising is that UK-listed companies have been battling against severe headwinds in recent years. Much of the underperformance of the UK market has happened since the 2016 Brexit referendum. This triggered a big fall in sterling, which was then followed by several years of sluggish economic growth and political turmoil. There has also been a massive sell‑off of UK equities by UK pension funds over the past 30 years. 

It is debatable how big the direct impact of this has been on prices. However, Michael Tory, co-founder of advisory firm Ondra Partners, says there has been a more serious consequence — the pressure on UK quoted companies to increase dividend payments at the expense of investment and a fall in the amount of equity raised.

Tory contends the result can be seen in the “terminal value” of UK companies — the difference between their market values and the expected values of their dividends and buy-backs over the subsequent 10 years. He calculates that the terminal value of UK‑quoted companies has almost halved since 2006; those of French and German companies rose by 50%, and US ones soared 300%.

This certainly looks grim. But there is reason to hope that the trend can be reversed — after all, pension funds’ holdings of UK equities can hardly fall much further and there is a effort in government and the City to find ways to get them to invest more.

One proposed remedy is to use the Pension Protection Fund as a consolidation vehicle for private sector final salary schemes. Powerful City interests oppose that idea, but it is also gaining support. Financial Times columnist Martin Wolf recently used Tory’s analysis to call for radical pension fund reform. His call was endorsed in a letter signed by an impressive group of industrialists and investors. 

A solution to the pension fund issue is unlikely to materialise any time soon, but other UK headwinds are reversing and the government does seem serious about tackling some of the other obstacles. 

Main threat

Yet competition from other exchanges is not the only, or perhaps even the most seriou, threat facing the LSE.

Various private equity firms, including EQT, are looking at ways to bypass stock markets by conducting private auctions of shares in their portfolio companies. Christian Sinding, the head of EQT, explains that IPO markets in general are “dysfunctional”. The recent New York debut of Birkenstock, the shares of which are now trading way below the offer price, shows how tricky IPOs are these days — not least because of the shrinking pool of active long-only funds.

Whatever London’s particular challenges, all stock exchanges need to find ways to stop private markets eating their lunch.

 David Wighton is a columnist for PEN’s sister title Financial News


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