Some black holes in the global market
It's a familiar theme. Trot along to any investor conference in the coming months and you are bound to come across it. Indeed, chances are that it's lurking in the wings at most financial community gatherings. You may even have come across it yourself this very day.
What theme is this that wends its evil way into all our working lives? The global market, that's what. It appears in many guises. You may have discovered it dressed up as global investing or a global view or global sectoral analysis or just plain old globalization. Everyone was talking the talk in the last few years of the 1990s, even if they had not actually got round to walking the walk as yet. The web was a recurring theme in all of this. Whatever the cause, you can bet your bottom dollar that our global friends are going to become a whole lot more virulent in this third millennium.
The reality remains somewhat different. Global markets are not here yet – even in the most global of sectors, such as pharmaceuticals. If you want the proof, take a look at the wildly different ratings ascribed to companies from the same sector but resident in different markets. Sure, companies are going to have divergent multiples according to growth potential, management capabilities and so on. That goes without saying. But take a look at an average of PEs across a whole sector and you can see significant differences in different markets. In the long run those differences can have a real impact upon a company's acquisition program, its strategy, and its ability to compete in – wait for it – global markets.
Doing the numbers
Gary Schieneman, a comparative global equity strategist, at Merrill Lynch in New York has been keeping himself busy doing the sums. His analyst team has released a series of reports looking at cross-border valuation issues in a number of broad industrial sectors. The latest report on 25 utility company valuations across the globe once again backs up the theory of widely divergent ratings: multiples of the US stocks in the study were an average 27 percent lower than non-US companies. And it's not just utilities where such wide discrepancies exist. Matthias Fankhauser, investor relations officer at Ciba Specialty Chemicals in Basel, also notes that in his industry the Swiss multiple is substantially higher than for his US competitors. In many other sectors, the reverse is the case with multiples being considerably higher in the US market.
'Clearly there are differences in the way stocks are rated in different markets,' says Schieneman at Merrill Lynch. He points to the link up between Daimler and Chrysler as being a commonly cited case of wide differences, with the German company trading on multiples around double that of its US counterpart at the time of the merger.
The utility valuation report points to a number of key factors relevant to this sector which may help in explaining the discrepancies in ratings between the US and non-US markets. These include uncertainty associated with deregulation and restructuring; accounting differences; and deferral of costs by the US companies. 'Outside the US, utilities tend to make up a much more significant part of the index,' says Schieneman. 'In the US that's just not the case.'
He notes that these and other factors play a similar role in other sectors, too. 'Part of it is just custom at the moment,' he adds, pointing to the relative attention on different industries in different markets by the financial community. 'As we move to more of a global sector approach those differences will be reduced but they won't necessarily be eliminated because of country issues.'
Doing a runner
One of the most public cases in recent times of comparative equity valuations having a real impact on corporate strategy is that of LucasVarity (see Investor Relations, February 1999). For those who don't recall, the UK-based automotive company took a motion to change its domicile to the US to a shareholder vote – and lost. It was a close run thing. Just a few months later it was acquired by US-based defense, space and automotive group TRW. One of LucasVarity's key arguments for its original attempt to relocate was that US automotive companies were trading on significantly higher multiples than it could ever hope to attain in the UK: the specialist analyst community was based in the States and US companies had a real advantage in the global consolidation game because of their higher valued paper.
Joseph Cantie, formerly investor relations officer at LucasVarity and now vice president of investor relations at TRW in the US, notes that the UK's automotive market has changed significantly since those heady days of late 1998 when he and his senior management colleagues were busy doing the rounds of investors reciting the arguments for a change of domicile. 'There are very few pure automotive plays in the sector anymore and one of the reasons is that they have pretty much vacated the UK market.'
Cantie passionately believes that the location of the specialized analyst following in any given sector is a significant determinant of ratings. Higher multiples will still gravitate toward the market where there is a real understanding of the industry in question. In LucasVarity's case that analyst following was in the US and it gave US companies a real and immediate advantage over UK competitors. The outcome? The UK-owned side of the industry all but disappears due to acquisition. 'It is a snowball effect. It allows [the higher rated companies] to do acquisitions using their paper which, in turn, allows them to gain a better valuation.'
So much for the global market place. 'While it all looks good in theory, there are still lots of things which prevent that,' notes Cantie. 'The market structure remains a long way away from truly global investing.' He points to the desire of investors to match liabilities to assets, implying that, for example, a UK-based institution will look more predominantly toward UK-based companies so if one sector is fairly small then there will be relatively little investment in quality analyst coverage. Again, the snowball effect then kicks in.
Extreme route
Of course, the LucasVarity situation was something of an extreme. Few companies would dream of switching domicile for ratings purposes – even if it was practical. In most cases the answer may lie in accessing the lower cost of capital by listing on an overseas exchange or, even more simply, putting more investor relations resources into targeting the foreign market in question.
The exchange listing option was probably most visible in the late 1980s rush to Tokyo by European and North American blue chips, all of them keen to cash in on the extremely high PE ratios in the Japanese market at that time. Once again, times change. Today, the US remains the favored non-domestic route and, although the desire for higher multiples often plays a part in that decision to list overseas, it's not usually the prime driver.
Old Mutual's decision to list on the London Stock Exchange after demutualization was not driven by the ratings issue although, going forward, it may become more of an issue for the South African insurance giant. James Poole, director of investor relations, notes that the size of its IPO would have been too much for the Johannesburg market to bear and the London move had the added advantage of making the company's globalization strategy easier to achieve. Still, Poole does admit that Old Mutual is currently trading at a substantial discount to embedded value whereas many of the company's peers live life at a premium. 'We hope and expect that discount will disappear,' he notes, acknowledging that a London listing may help in that goal.
There are others who point out that seeking a better rating by spreading the investment base into other markets can lead to trouble if things go belly up. Philip Ward, a director at Gavin Anderson & Co in London and formerly head of investor relations at SmithKline Beecham, points out that if some non-US companies spend a lot of time and resource building up a substantial US element in their investor base they are then a hostage to economic factors completely outside of their jurisdiction. For example, if bond rates change they may find US investors dumping their stock like crazy. 'It's a bit like a sword of Damocles hanging over your head,' says Ward, adding that when economic fortunes change, institutional investors can act in a very parochial fashion. 'The investor relations skill lies in creating enough demand in your home market to ensure that if circumstances change that the demand exists there.'
Ward does not believe the truly global marketplace exists as yet but notes that some sectors – such as pharmaceuticals are moving in the right direction. 'The market classifies these stocks the world over in the same way and doesn't tolerate dramatic differences between valuations.' Still, he points out that with so much investing based on individual market indices – such as the Dow and the FTSE 100 – differences in average multiples are bound to exist in some sectors.
Duncan Learmouth, investor relations manager at Glaxo Wellcome in the UK, also believes that the pharmaceuticals industry is one of the few sectors which has moved into a truly global marketplace. 'With PEs, investors are paying a premium for higher growth but that's fairly highly correlated with different growth rates.' He adds that the move toward easier global comparisons has been helped by the rapid rate of consolidation in the pharmaceutical industry in recent times and many of the continental European pharma giants listing in London or the US.
Different planet
However, the pharmaceutical sector remains distinctly in the minority. Clear rating differences still exist market to market in most sectors and these discrepancies are likely to do so well into the future. So what can the poor, beleaguered investor relations professional do? Or isn't it even a problem? Most commentators suggest that it is most likely to become a problem if there is some serious global consolidation going on in your industry. Then, like LucasVarity, you may find that you are not able to compete on the acquisition front with your own paper.
It's back to Joseph Cantie for this one: 'You have to assess whether you are truly in the right market. With LucasVarity we said we weren't and I became heavily involved in presenting our case.' He adds that 99 percent of companies will conclude that they are naturally in the right market. 'Then if you are not getting the appropriate attention then the IR function becomes more critical. If there isn't a specialized analyst following then you have to take the story to investors directly which may mean you need more resources in your investor relations. Without sell-side help you may also have to open your doors and grant the investment community more access to the company.'