By Sean Neethling, Head of Investments at Morningstar South Africa
The increased number of companies de-listing from the JSE has elevated investor concerns about the investment outlook for SA Equities. The shortage of new listings, the relatively weak performance of local shares and depressed levels of business confidence have further exacerbated fears among market participants. While the de-listing trend is concerning, the debate is actually less about the number of de-listings and more about the level of market concentration and its impact on investment portfolios.
The graph below shows new listings have dropped off significantly since 2002 while de-listings have averaged more than 10 per year over the same period. The number of listed companies has reduced by almost half over that period with less than 300 companies listed today. It can also be seen that the market capitalisation of the FTSE/JSE All-Share Index (ALSI) has generally continued to increase. The ALSI today remains highly concentrated with the Top 40 shares accounting for approximately 85% of the index.
Reframing the debate
De-listings have had minimal impact on JSE trading and liquidity given the high levels of index concentration and size of the main index constituents. The direct impact of smaller companies exiting the market is also less meaningful when viewed through the lens of how equity funds are currently constructed.
Most of the companies that have de-listed were not core holdings in benchmark cognisant domestic equity portfolios. Approximately 70% of de-listings over the last five years would be categorised as small-cap or fledgling companies with market caps of less than R300 million, placing them largely outside the investable universe of fund managers tracking the index. There are exceptions but, on average, domestic equity funds holding the majority of pension and retirement assets have remained relatively unaffected by the shrinking opportunity set. In aggregate, investors have already been allocating capital as if the market is narrower than it actually is.
South Africa is also not unique in this matter, with net listings in developed European and UK markets also trending downwards as merger and acquisition (M&A) activity has largely outpaced initial private offerings (IPOs) in recent years.De-listings should be considered a normal part of the economic and capital cycles and are not necessarily negative events, especially where private markets are better at unlocking shareholder value.
Taking a company private allows management to focus on the long-term sustainability of the business and steer away from short-term sentiment and incentives of external passive minority investors. De-listings may also unlock value in a way that the traditional market mechanism failed to. For more active managers, identifying companies likely to be acquired at a premium to the current share price could potentially be a secondary part of the investment thesis.
De-listings may also improve market integrity. It could be argued that companies with less robust business models should not be listed in the first place. The incentive for companies to list is to unlock shareholder value through access to a wider pool of investors. However, the purpose of publicly listed markets is to create long-term shareholder wealth, not incubate companies that should be privately owned. These are very different from companies with stronger business models that happen to be too small for concentrated markets to unlock per-share value for shareholders.
Much ado about nothing then?
A narrower market crowds out active management. While the decline in the number of holdings is not necessarily especially significant for the average manager tracking the index, the shrinking universe does potentially constrain more benchmark-agnostic managers with a particular focus on small and mid-cap domestic equities. These companies trade with relatively less liquidity than the larger companies that make up the index and may take longer to attract the level of investor demand to generate expected returns.
Domestic small and mid-cap companies delivered exceptional returns in the two years following the COVID-19 pandemic market lows and do provide a differentiated payoff profile to larger index constituents. An acceleration of de-listings into more of these companies will limit the ability of more active managers to deliver alpha over time.
A continuously shrinking local investment universe will only serve to increase market concentration. Too much money ends up chasing too few investable opportunities which contributes to companies trading at inflated prices relative to fundamentals. At extremes, these companies become “too big to fail” given ownership in retirement and pension savings pools. A narrower opportunity set also potentially increases the volatility of returns at the index level. While increased volatility does not necessarily imply higher risk, it does expose client portfolios to large swings in investor sentiment.
Market concentration forces managers to seek more diversified investment ideas that may potentially be outside their circle of competence. The increase in Regulation 28 maximum offshore exposure to 45% is generally a good thing but exposes portfolios to both direct and indirect risks. Fund managers seeking diversified exposure can widen the investable universe by allocating to different countries, sectors and currencies, but may not have the internal resources to adequately research these markets. The key drivers of risk and return shift away from local markets where they may have a competitive advantage.
Managing risk in concentrated markets
The importance of portfolio construction is exceedingly important in an environment where market concentration has the potential to atypically skew investment performance, both in local and global markets.
Below are three parts of Morningstar’s investment process we use to mitigate the risk of market concentration in client portfolios.
Understand the key drivers of risk and return. Applying a valuation-driven approach allows us to shift allocations in line with our best global research ideas. Implementing these ideas through asset class building blocks gives us the ability to be more granular in tilting portfolios away from pockets of risk and towards pockets of opportunity. Deconstructing the underlying components of risk and return enables the investment thesis to be tracked relative to expectations and adapted should market conditions materially change.
Maintain a forward-looking view. Using backwards-looking risk and return metrics is not especially useful where markets have detached from fundamentals. Understanding the expected risk and return profile of the underlying assets as well as the forward-looking correlation of those assets provides an additional layer of robustness to complement our valuation work.
Our investment process also uses a broader reward-for-risk framework that assesses market conditions across several key metrics. The aim is to construct portfolios that are resilient enough to withstand a wide range of potential outcomes.
Understand sources of manager alpha. In concentrated markets undergoing both cyclical and structural change, historical track records may not capture manager skill. An example in the local market is the higher 45% offshore allocation that potentially provides increased diversification benefits but not without increased risks. Identifying managers with the right people, process and incentive structures is likely to be a key differentiator in driving future returns.
Combining local and global managers in a portfolio is even more important. It’s not as simple as buying S.A. managers to manage S.A. assets and global managers for global assets. Our manager research and selection process leverage significantly off a global investment team that collaborates to bring our best ideas into client portfolios and specifically considers forward-looking alpha expectations.
The debate around the increase in JSE de-listings is less about the number and more about the size of the companies exiting. The trend is also not unique to South Africa with net listings across the developed world declining, and high levels of market concentration playing an outsized role in driving investment performance. De-listings are not necessarily a bad thing but both investors and regulators have a role to play in not crowding out shareholder value creation in companies outside the larger index constituents.