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The Irish Stock Exchange is still not an attractive option for small firms Back  
The Irish Stock Exchange is not meeting the needs of small cap Irish firms and is in danger of damaging these companies’ ability to raise venture capital, according to recent research by the University of Limerick. Sheila Killian and Martin Breen find that ISE listing is becoming a less viable option for small firms.
With indigenous technology firms seeking listings on teh NASDAQ or Neur markets and the euro triggering a drift if Irish investment funds abroad, ISE listing is becoming a less attractive option for small firms.

The increased popularity of management buy-outs underlies the problem and suggests that the ISE is failing small cap companies. As the graph shows, small stocks under-performed the ISEQ since 1996, and that gap has widened since the introduction of the euro. In 2000, the ISEQ showed a return of 12.5 per cent, while the portfolio of small cap firms gave a negative return of just over 6 per cent.

Of course, small caps cannot be directly compared with the larger plcs. In general, small stocks earn a higher rate of return than large stock, to compensate investors for risk. As a corollary, they tend to be underpriced relative to their performance.

One reason for the relatively poor performance of smaller firms is liquidity. Many smaller firms are closely held by a small, cohesive group of shareholders, and trading is sporadic. Such thin trading negates the key benefit of investing in a listed stock. If a large institution invests in a smaller firm, it is difficult for them to sell without impacting the price adversely. This leads them to either avoid the stock, or buy for the long term thereby further reducing the liquidity.

However, liquidity can also be used to mask other issues. Another concern is the increase in passive fund management. Institutional investment capital increasingly follows index-linked funds, and the larger indices emphasise market capitalisation as a criterion for inclusion. For a fund manager to invest in a smaller firm outside the indices, they must attain a return that will compensate for increased costs incurred.

Globalisation compounds the problems. For example, the euro has removed the foreign exchange risk to Irish pension funds of moving outside of Ireland. As a consequence, the proportion of funds invested on the ISE declined from almost 27 per cent to under 20 per cent from 1999 to 2000, and is likely to fall further this year. This shift of investment would have a nil net effect if international investors came in to meet the void. However, when they do, lacking local knowledge, it is easier to track the few Irish firms at the top of the market capitalisation list in their sector, and thus widely analysed. This augments a global trend towards larger firms.

Given that that this is a global issue, are small caps in the ISE doing as well as could be expected? Obviously, their performance cannot be measured against large firms. It is also noteworthy that in general, the small Irish plcs are based in ‘old economy’ industries, (see chart) though whether this is a cause or an effect of the relative under-performance is not clear. This makes a comparison with the Neur or the NASDAQ questionable. We therefore compared Irish mall caps to a matched sample of smaller firms quoted on the LSE.

The Irish firms were found to have lower price earnings ratios than their UK equivalents, suggesting a relative under-valuation. However, they also recorded considerably higher earnings per share over a five year period, suggesting a superior performance. These differences are statistically significant, which means that while Irish small caps are currently outperforming the UK firms, they remain undervalued relative to those less successful small firms on a rival stock exchange.

Part of the difference may be due to the non-effect of the euro in Britain. Since a common currency is not drawing UK investment funds overseas, smaller UK firms may still have the luxury of a captive investment fund of sterling. But could more be done here, by the firms themselves and other players, to stimulate market interest in small Irish stocks? The whole area of investor relations seems to be a relatively new concept to many Irish firms. One analyst interviewed in the course of this research noted that many of the smaller plcs are run like private companies, and feel they do not need to publicise their business. Relative to larger firms, for example, few of the small caps have informative websites, with downloadable financials. Given the need to attract investment from abroad, this seems a logical first step. Other positive signals to shareholders would include generous dividends, and share repurchases, as recently utilised by Abbey and Ardagh.

Arguably, there are three other main players who might possibly play a role: government, analysts/large investors, and the ISE. The main issue to be addressed by government is the rate of stamp duty on stock exchange transactions, currently four times that which applies in Britain. It is difficult to see what direct action could be taken by analysts and investors. While it is in their best interest to promote a vibrant domestic capital market, this conflicts with their more immediate objective to obtain high returns. Stockbrokers have a clear motivation to market small caps, but find it difficult to attract foreign institutional investment.

This leaves the ISE to come to the aid of small caps, and on one level, it has been pro-active in its approach to the problem. The introduction of the Xetra trading platform gave small stocks on the ISE visibility on trading screens throughout Europe. In 1997 the ISE launched the Developing Companies Market (DCM), along the lines of the successful AIM in London, as a stepping-stone to the main exchange. While some firms have progressed from this market to a full listing, there are only four firms currently listed on the DCM, all of which are also listed on the AIM. The small cap index was set up in December, 1999, but has done little to stimulate interest. With increasing globalisation, indices based on geographic boundaries are less relevant than larger sectoral indices. At the moment there is no benchmark small cap index across the Eurozone. Perhaps, as suggested by Peter Bacon in his 1999 report, the ISE should seek to establish one in collaboration with other European exchanges.

Finally, last September, a specialist technology index, the ITEQ was opened, with similar requirements to the NASDAQ and Neur. A major advantage of the ITEQ is that it permits trading in ADRs which may be traded across exchanges in the US, increasing liquidity. There are six firms currently listed.

All in all, the future for small caps on the ISE looks bleak. We can expect an increase in firms being taken private by means of management buyouts, and an increase in merger and acquisition activity. This consolidation may well reduce the number of small listed firms below the viable level.

The success of the ITEQ will be key in maintaining indigenous technology stocks on a domestic exchange. It is likely that most of the firms seeking a NASDAQ or Neur listing will also list on ITEQ. However, this does not make it viable for some firms to list only on ITEQ. The increased visibility and more attuned investor base of markets such as the Neur may be too attractive to make ITEQ a sole listing choice.

Given the general malaise, we may also expect fewer small companies to seek an ISE listing. At the moment, it would be simpler for them to raise funds through low-cost debt. Most worryingly, this could have a knock-on effect on the supply of venture capital. Flotation is a logical exit mechanism for venture capitalists. The risk is that if the ISE fails to meet the needs of small cap firms, venture capitalists may in turn shy away from industries which would traditionally aim for a listing there.

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