Cheshire-based Dechra Pharmaceuticals plc (Dechra) is an excellent business. It operates in the attractive veterinary pharmaceuticals market and has achieved strong growth, earnings per share¹ have compounded by +13.6% p.a. over the past five years. So in a period where shares had been trading soft, you can understand the frustration when Dechra disclosed (following a leak) that it was in talks with Swedish private equity house EQT to be taken over at a price, £40.70 per share, and valuation multiple, which the company traded at just last spring.
Following a downgrade to full-year profit guidance by Dechra, the takeover price has now been proposed at £38.75 per share. Nonetheless, this anecdotal example did get me thinking more broadly about the vitality of the UK’s equity market which appears to have been waning. The evidence does unfortunately back the view that it is being hollowed out: since 2008 the number of listed companies has declined by a whopping 40%. The main causes are:
- companies being acquired or moving their primary listings abroad due to the relatively lower valuations attained on a UK listing; and
- fewer companies coming to market via initial public offerings (IPOs) — this is where limited companies are floated on a public stock exchange.
Simon French, Chief Economist and Head of Research at Panmure Gordon, has carried out research which shows publicly traded companies in the UK (PLCs) are consistently trading at a discount compared to international peers. This shows that a company with earnings per share growth of +50% over the next three years will have a valuation² of just 16x its earnings in the UK, versus 19x in Europe and 24x in the US.
French says multiple factors are to blame. Brexit has not helped, with a clear UK discount emerging in mid-2016. Liquidity (the market value of shares traded) remains an issue; over the last three months, only 150 UK PLCs traded more than $5m in volume per day (due to lack of UK pension investment, discussed later), whilst all the companies trading on the US and European-based S&P500 and Stoxx600 indexes did. There is also the burden of being a PLC (which brings additional reporting, environmental social and governance (ESG) and cost responsibilities for companies) meaning some of the UK’s most investable companies choose to remain as limited companies and do not become publicly traded.
UK IPOs, although poor of late, do appear to have performed relatively in line with international peers. The UK has however missed out on a number of high profile listings, including that of Arm - a Cambridge-based semiconductor chip designer - with owner Softbank choosing to list in the US instead. In addition to French’s points, other factors have increased barriers to listing, such as onerous rules requiring shareholder votes on transactions between UK-listed companies and related parties (this was a factor blamed by Softbank for their decision to not list Arm in the UK). Other barriers include the often confusing two tier UK standard and premium listing structure, and the lower acceptance of high executive pay in the UK compared to the US, making executive talent recruitment much easier in the latter. Some of these existing measures do improve corporate governance and increase shareholder protection, but this makes little difference if businesses do not want to list in the UK. The Financial Conduct Authority (FCA) has said it is open to ‘streamlining’ policies and procedures in order to address these problems.
Yet, at the heart of the UK’s declining equity market lies a lack of funding for higher risk, higher reward investments, particularly from pension funds. According to the OECD (an intergovernmental organisation which promotes pro-economic growth policies), the proportion of UK pension fund assets invested in equities was just c.26% in 2021, down from c.56% in 2001. This difference amounts to hundreds of billions of pounds which could have been used to fund UK companies, particularly smaller/growing businesses that struggle to access debt financing under economical terms. This shift, The Financial Times notes, has been spurred by IFRS17, an accounting standard introduced in 2000 which requires companies to calculate the surplus/deficit on their defined benefit schemes each year and disclose any deficit as a liability in their accounts (discussed further in this edition of Prospects ‘understanding finance’). Consequently, plan sponsors (e.g. corporates) have pressured trustees to shift their asset allocation to lower risk, lower return fixed income assets such as bonds, and away from equities, where prices are more volatile, even though they are the asset class which has historically delivered the best inflation-adjusted returns.
At the heart of the UK’s declining equity market lies a lack of funding for higher risk, higher reward investments.
Many defined benefit pension schemes are now closed to new participants, but defined contribution schemes often do not produce adequate returns. The predominant cause is a lack of risk culture, despite the fact that many pension beneficiaries will be unable to meet their retirement needs by investing solely in fixed income assets. Robert Swannell, a director of the Investor Forum and a senior adviser at Citi, calls it “among the biggest financial issues facing the UK government today” and says the switch to defined contribution schemes needs to be accompanied by a financial literacy campaign and “huge societal education about risk and return”.
There is no silver bullet and the many required reforms will take time to implement.
The necessary changes will therefore require government intervention, with measures expected to be published this autumn. These include plans to exclude performance fees from caps on workplace pension charges, allowing more schemes to invest in private assets. The idea of a mandated allocation to growth equity could also be of merit, with the automatic enrolment of workers into company retirement schemes introduced in 2012 proving to be a successful example of such a scheme. On the defined benefit side, the further pooling of assets and the separation of pension performance from corporate sponsors’ balance sheets would allow UK schemes to achieve greater scale and focus on long-term performance. Such measures would likely result in greater equity exposure (public and private) and could help returns match that of successful Canadian and Australian pension funds, which have much more flexible mandates.
Ultimately, there is no silver bullet and the many required reforms will take time to implement. In my Prospects editorial, Winter 2020, ‘Change is happening in the UK…but let’s try and make it positive: how the UK can boost its productivity’, I prosed that the UK, and its equity market, have the potential to flourish. We are a creative and innovate nation, however we do lack consistent political will to push through policies that are materially impactful over the long term, but are slow to take effect. On behalf of our clients, JM Finn can invest in brilliant companies in almost any market in the world, but we should still strive for a thriving domestic market – capitalism remains the best driver of economic and social good.
¹ Earnings per share (EPS) is calculated as a company’s net profit divided by the number of shares it has outstanding.
² Company valuations (‘price/earnings ratios’) are calculated as the share price of a company divided by its earnings per share.
Illustration by Jordan Atkinson
