Author: Neil Shah, Director at Edison Group
A few months ago, leading portfolio manager Nick Train described the modern City of London, stingingly, as a “backwater in 21st century equity markets”. The numbers seem to confirm this. Over the past five years, the number of companies listed on the FTSE 100, FTSE 250, SmallCap and Fledgling indices has fallen by 20%.
Financial centres have their ups and downs. But this is beginning to look worryingly like a trend, and it has prompted a bout of soul-searching in the City – and in Whitehall. It is now hoped that the right combination of rule changes will allow for the natural advantages of the City – talent, institutional knowledge, a first-class funding ecosystem, and the English legal system – to reassert themselves.
This was the logic behind Chancellor Jeremy Hunt’s recent ‘Mansion House’ speech, which set out a number of regulatory changes and active measures to try to reverse the decline of the City of London. Changes to listing rules were promised, as well as measures to encourage pension funds to invest in British equities. Also announced, but less often discussed, has been the Chancellor’s decision to accept all the recommendations of a review into British investment research, led by the City lawyer Rachel Kent.
But the issue is hardly secondary. It is no exaggeration to say that the current problems with the British investment research landscape are acting as a millstone around the neck of UK capital markets. The Mansion House reforms are a bold attempt to deal with these problems, and will do much to revitalise these markets, and, by extension, the City as a whole.
Misallocating capital
One major reason for the City of London’s current malaise is a dearth of investment research to inform decisions. The field has been in decline in the UK for some time: major firms have cut their investment research budgets, and coverage of UK SMEs has become particularly thin.
Insufficient investment research means that capital is allocated less efficiently. Asset managers and institutional investors remain ignorant of the opportunities, and innovative new firms are left to languish in obscurity. It is therefore little wonder why UK stocks trade at a discount of roughly 20% compared with global peers.
This represents a permanent drain on British capital markets – and on the economy at large. In this kind of investment research environment, investors are more likely to simply default to the established options known to them. Expanding firms do not get the investment they need, and investors, ultimately, – do not get optimal returns.
This also has very direct implications on the propensity of companies to list on the LSE – the decline of which has often been taken as a proxy for the decline of the City writ large. A lack of quality investment research can lead to inappropriate valuations, which pushes would-be IPOs to list elsewhere. An example of this can be found in the Turkish soda ash giant WE Soda’s recent decision to cancel its LSE IPO. According to the company, this decision was due in large part to its feeling that it had been undervalued and would therefore not be able to attract enough investment on the London exchange. This is not a perfect analogy, as WE Soda is a very prominent firm, known to all industry observers. But it does illustrate the problem. There is an impression that UK capital markets do not have the information needed to value investments correctly – and it is hurting the City.
Information unlocks investment
If the City is to start to turn things around, then the UK’s investment research sector needs to be revived. In this regard, the Mansion House reforms represent a very good start.
For one, the reforms will allow buyers of investment research to list this as part of their execution costs – a rowing back of the EU’s MiFID II rules, which still sit on the UK statute book. The reforms will also broaden retail investors’ access to research; attempt to generate issuer-sponsored research; simplify the sector’s regulations; and broaden access to research surrounding a firm’s IPO.
Interestingly, the announcement also spoke of a digital platform for investment research – almost a kind of Netflix. This would be funded by a third party of some description, with the view to securing at least three research reports by analysts for each company. This would, of course, be particularly beneficial to SMEs, which have probably had the toughest time securing analyst coverage.
These reforms will make all the difference. Broadening access to investment research will serve to drive up its quality and quantity, which will in turn increase firms’ willingness to pay for it. In an uncertain investment landscape, there is a need for trusted analysts to help investors make sound decisions with their money. These reforms significantly enhance this critical sector, helping to revive Britain’s capital markets, the City and, most important of all, the UK economy.
