Friday, August 22, 2014

John Kay: Decline in Equity Issuance

In 2012, John Kay produced a report on UK equity markets that was focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

This post from last year focused on the first section of that report.

John Kay on Equity Markets: Exit, Voice, and Short-termism

In the second section of the report, the emphasis is on new equity issuance or, more specifically, the lack of it:

"Equity markets have not been an important source of capital for new investment in British business for many years. Large UK companies are self-financing – the cash flow they obtain from operations through profits and depreciation is more than sufficient for their investment needs. This is true of the quoted company sector as a whole and of a large majority of companies within it."

and

"Finance raised through placings and rights issues by established companies, and initial public offerings (IPOs) by new companies, have generally been more than offset by the acquisition of shares for cash in takeovers and through share buyback..."

As a result, the issuance of equities has been negative over the last decade even if the situation has recently improved somewhat.

Why has there been a decline?

"There are many reasons for the decline in the role of equity issues in investment. In a modern economy, investment in physical capital is much less important than it was."

Yet...

"Even companies in sectors that have large capital requirements – such as oil and utilities – make little or no use of primary equity markets, relying instead on debt and internal funding."

There are many explanations for why equity issuance has declined -- and some of them are valid to an extent -- but the report states "we do not find them adequate" while adding "we believe the fundamental reasons go deeper, and reflect the nature of financial intermediation itself."

The combined impact of regulatory and cultural changes over the years led to "the rise of an ethos which emphasised transactions and trading over relationships. This ethos permeated all areas" of financial services and "the shift from relationship to trading, from voice to exit, came to affect not only the interaction between shareholders and companies but between corporate executives and their companies: some managers came to see themselves as traders, engaged in the management of a portfolio of businesses to which they owed no particular attachment."

The United States has had more than its fair share of influence on the changes that have occurred in recent decades. Equity markets, of course, need to facilitate the funding of new and existing businesses. If working well, equity capital efficiently gets where it's needed while misallocation and mispricing is minimized.

Increasingly, that's not their primary function.

Equity markets are also "one of the means by which investors who support fledgling companies can hope to realise value. Equity markets provide a means of oversight of the principal mechanism of capital allocation, which takes place within companies. Promoting stewardship and good corporate governance is not an incidental function of equity markets."

Not only is it important "that equity markets remain an attractive means of obtaining funding", policies should "ensure there are no unnecessary disincentives to using equity markets, either for companies or for their investors. And we believe that our recommendations to encourage asset managers to act as long-term stewards of more concentrated, less liquid equity portfolios will mean a greater willingness to invest funds across a broader range of companies, including smaller businesses who wish to raise equity finance, but are currently unable to do so."

Warren Buffett's long-term oriented investing behavior -- whether in equity markets or how Berkshire Hathaway's (BRKa) many businesses are operated -- would be a prime example of what would become more commonplace.

This requires no less than a fundamental culture change.

For an example closer to home in the UK, as this article points out, look no further than the way that Neil Woodford operates:

"To many, he [Woodford] is an example of what John Kay, commissioned by the government to encourage long-term investment, should look for in a fund manager, holding shares for 15 years rather than switching in and out in search of a quick buck."

Woodford recently left Invesco after more than 25 years at the firm to start a fund management company and launched a new fund, Woodford Equity Income.

There are certainly a number of other good examples.

The focus of John Kay's work is the UK but many of the same problems, as well as potential solutions, are more than a little bit similar to the US.

IPOs have come back somewhat recently in the US, though still are well below what we saw in the 1990s.

Progress on this front starts with recognizing the costly long-term implications of not making some sensible adjustments.

Adam

Long position in BRKa established at much lower than recent market prices

* Excerpts in this post are from sections 2.6, 2.7, 2.12, 2.13, 2.18, 2.28, 2.32, and 2.33 of the report.
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