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Investment managers concentrate on strong fundamentals Back  
While the rationale for corporate restructuring and M&A among small cap stocks is strong, the difficulty in predicting which companies will restructure means the focus should be on fundamentals, writes Lenny McLoughlin.
In the Irish equity market, outside the top ten stocks which account for approx 74% of the market, roughly half of the remaining stocks trade on 2001 P/E's of less than 10x while up to two thirds of these trade on P/E's of less than 7.5x or on an earnings yield of over 13.3%. This is at a time when investors are finding it difficult in most international markets to justify P/E's at or close to historic highs.

How can Irish stocks trade at such valuation levels and why is the market ignoring the apparent 'bargains' which have become available?

Small cap woes

The bull market in global equities in recent years has been very much large cap driven with the result that the relative valuations of small caps have suffered. This in part is due to the increasing size of investment funds with the consequent increased emphasis on large, liquid stocks and a desire to achieve exposure to scale and market share which is offered by large cap stocks and not necessarily by small caps.

One of the difficulties faced by Irish small caps is their relatively small size even in the small cap sphere. Outside the top twenty stocks in the ISEQ, no company has a market cap of greater than IEP500m which is often the threshold used by international investors when screening potential candidates for inclusion in smaller cap funds. Below this level, liquidity issues arise which prevent institutions from building or exiting positions in stocks with ease, a factor which is made even more difficult in Ireland given that the free float of many Irish stocks is restricted and the limited turnover in many stocks on a daily basis.

Many small cap issues in Ireland are also involved in what could be termed 'old economy industries' which are mature and ex-growth as opposed to the current in vogue 'new economy' sectors such as technology, telecoms and media which investors are chasing across the globe and where valuations have been pushed to levels undreamed of even up to a few months ago. It is not only in Ireland that investors are side-stepping these traditional sectors and valuations elsewhere have also fallen to very low relative ratings.

A further issue which has driven shares down in Ireland is due to domestic investment managers themselves and the desire of trustees to reduce weightings in Ireland in favour of Europe following the introduction of the euro. Weightings of managed funds in Irish equities have fallen from almost 40% two years ago to about 24% now with some estimates that this will decline to 15% over the next few years. If this is the case Irish equities in general will continue to come under pressure.


What can corporates do in this environment to unlock the value in their share prices which the market may be undervaluing?

In the Irish market over the last nine months or so there have been a number of instances where corporate activity has indicated that industry participants are willing to place far higher values on companies than the market. Powerscreen, Clondalkin, Boxmore, ESAT and our own parent, Hibernian Group have all been successfully bid for either by other industry players or by management at levels on average about 55% above those at which they had been trading prior to any approach.

The benefit of a quote can be reduced for companies when valuations fall significantly with the ability to raise cash or use their stock as currency in deals severely curtailed. Companies with ambition, which are involved in ex-growth industries or which lack scale should examine ways to move the company onto a higher growth path. If internal resources which will allow this are not in existence, companies should consider mergers or the possibility of being acquired by others to enable the full potential of the company to be realised.

Mergers and takeovers

While mergers and acquisitions are sometimes justified on the basis of cost savings by taking out duplicated cost structures in a combined entity, these mergers/acquisitions tend to be more defensive in nature and result in once off cost savings, after which the fundamental issue of lack of growth prospects may well remain. The essential element of successful corporate activity is to boost growth prospects and cost savings alone are not sufficient to ensure that combining companies will boost shareholder value in the longer term.

Within any equity market it is always difficult to highlight which stocks are definitely going to become involved in corporate activity of some form. Ireland is no exception and while many small caps may be trading at what could be perceived as extremely low valuations which could lead to a merger or acquisition, we at Hibernian Investment Managers prefer to concentrate on stocks which offer strong fundamentals to support them.

The opportunity cost of holding potential takeover targets given the length time involved in corporate deals coming to fruition also encourages us to focus primarily on stocks which offer strong prospects based on their existing structure. In this regard, in our Irish smaller cap exposure, core positions are held in Kingspan, Jurys, Grafton, Green Property and United Drug among others.

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