Looking forward to the share price pendulum swinging
Laura Foll, Co-manager of Henderson Opportunities Trust, discusses the opportunities in UK equities if 2023 sees a bounce in share prices.
As investors, we care deeply about whether share prices rise or fall – our savings are tied up in them. But few stop to think about the impact on the companies themselves. Falling share prices can have a real knock-on effect.
Earlier this year, one of our holdings – a small British company – was about to sign off a big overseas acquisition. Management had been negotiating the terms for 12 months or more. To us as shareholders it seemed a good deal at a fair price and one that would create synergies for both companies and therefore enhanced earnings. But just as managers were about to sign the contract the UK company’s share price took a tumble. It was caught in the slipstream of a dive that has hit many small and mid-sized businesses in the UK this year. As I write the FTSE AIM All-Share index is down around a third since January.
Unfortunately, a significant portion of the cash for this deal was coming from equity finance. And with the share price down there was insufficient money to fund the acquisition. Management at the company being bought would not take less. The deal was off.
This has repercussions. This company has lost a great opportunity for growth. It might not get it again. We speak to the managers regularly. To say they were frustrated is a gross understatement. They had put so many hours into negotiations and spent so much on legal and professional advice to support it. It was a big disappointment for us as shareholders too.
Paying fair
Low share prices can be the way the market puts the brakes on poorly funded companies with dismal acquisition records from doing more deals. Share prices punish poor capital allocation and reward good management.
But 2022 was the year many companies found themselves penalised through no fault of their own.
Those weaker share prices, which represent a potential buying opportunity for investors, can also limit our potential rewards if they cut off a route to growth through acquisition from companies that raise funds through share issuances.
Unmerited low valuations also make companies more vulnerable to acquisition themselves. That can be distracting for senior management and impair the chances of recruiting and keeping good staff, who may worry about the implications for their job if an overseas buyer snaps the business up.
Falling share prices can undermine a company’s long-term incentive plans (LTIPs) as well. If staff are rewarded with shares and these are worth less, then so is the incentive. And that adds to the challenge when you are looking to hire the best staff possible.
Cures?
The fall this year, unfortunately, comes on top of a post-Brexit drag on UK share prices. Before Brexit the MSCI UK index was about 16% cheaper on average than the MSCI World (which has nearly 70% exposure to the US). Today that discount is nearer 35%.
How the relative value of British companies has fallen since 2016
Too much money has flown from UK markets, and in particular from pension funds and insurance companies – 25 years ago they made up around half the ownership of the UK equity market. Today it is less than 5%.
We need to reverse those money flows. Perhaps we can. Incentivising pension funds and insurance companies to buy British would help. UK companies buying back their own shares can be beneficial and attract buyers but is not easy for smaller companies with poor liquidity.
Perhaps the best way is for a change in performance. Sentiment towards the UK is so poor at the moment that it would only take companies to perform less bad than expected for the momentum to slow and even change direction.
I think that is possible. There are about a thousand companies quoted on the main list and AIM. A significant number are continuing to grow sales and earnings and will become substantially larger over the next few years, regardless of the economic backdrop.
The UK market probably offers some of the best investing opportunities around for investors who are selective.
Markets are like pendulums. They swing too far. At some point the pendulum will turn. And that will unwind the negative forces we have seen in the past year. It could mean a sharp bounce in share prices and in the fortunes of smaller companies. Let’s hope 2023 is the year that happens.
Laura Foll is co-manager of the Henderson Opportunities Trust and the Lowland Investment Company.
