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The changing challenges of the Irish equity market Back  
Having enjoyed a decade of growth and diversification of investors, Irish equities are now suffering from a flight of investment to other jurisdictions, writes Robbie Kelleher. He says that the dramatic events of late have left Irish equities undervalued.
For many years, throughout the 1990’s and the current decade, the Irish equity market was a significant out-performer relative to most other European markets. If we take 10 years ago as the base, the ISEQ had outperformed the FTSE Eurofirst 300 by more than 50 per cent by the end of 2006.
Robbie Kelleher

But all that has changed dramatically this year. Having got within a whisker of 10,000 in the early days of June, the ISEQ has recently been trading well below the 7,000 mark.

Part of the explanation reflects the difficulties equity markets in general have encountered in recent months. Following the sub-prime fallout and weakening housing markets in the US, banks and construction stocks have been particularly affected.

But that only goes a small part of the way in explaining recent moves. Year to date the ISEQ is down almost 30 per cent, whereas markets in Europe are broadly flat over this same time period. Germany is up 16 per cent and Spain is up 8 per cent.

International investor concerns about a collapse in the Irish housing market and the subsequent knock-on effects into the overall economy have been the main factor behind the fall in Irish share prices.

We do indeed accept that the Irish housing market is in the midst of a sharp correction both in terms of prices and, more particularly, the volume of activity in the sector. Housing starts are down 60 per cent year-on-year and house completions look set to fall from nearly 90,000 in 2006 to less than 50,000 in 2008.

As a result, we expect the pace of growth in the Irish economy to slow to somewhere between 2 per cent and 3 per cent next year. That is well off the heady pace of expansion we have become accustomed to in recent years, but would still leave Ireland as one of the faster growing economies in Europe.

In that sense we believe the recent fall in Irish share prices greatly exaggerates the threat posed by this slowdown to Irish companies. More than 50 per cent of profits earned by companies quoted on the market come from outside of Ireland.Irish banks, for example, are trading at a price earnings ratio of not much more than six times. The market is effectively saying they believe profits will fall by 30 per cent to 40 per cent next year. We think that is highly unlikely and, hence, we would see very a significant upside to Irish share prices in 2008.

Normally, one associates weak equity markets with falling and low volumes. That certainly has not been the case in Dublin this year. Since 2001, average daily volumes in Irish equities have increased from a little over €150 million a day to more than €700 million so far in 2007.

In large part, the increase in daily turnover reflects the changing ownership of the market, a trend that got firmly underway after the formation of the euro in January 1999. At the end of 1998, Irish pension funds had, in aggregate, some 26 per cent of their assets invested in Irish equities. At the same time, AIB and Bank of Ireland between them accounted for almost 40 per cent of the entire market capitalisation. Indeed excluding Elan, where Irish pension funds had a very low weighting, the two banks accounted for 46 per cent of the market.

Hence a typical Irish pension fund held about 12 per cent of their entire assets in the two Irish clearing banks. That was a stock and sector specific risk that many actuaries felt uncomfortable with. The creation of the new eurozone enabled them to diversify their asset base away from Ireland without incurring an exchange rate risk.

Within three years the proportion of funds held in Irish equities had declined by 10 percentage points from 26 per cent to 16 per cent. Since then the pace of decline has been gradual but is likely to lurch sharply downwards again this year, not because of any widespread selling of Irish equities by Irish institutions but because of the valuation impact of the huge under-performance by the Irish equity market this year.

We believe that the aggregate Irish weighting will decline to around 8 per cent by the end of 2007. The corollary to the reduced weighting of Irish equities in Irish pension funds has been increased holdings by international investors.

Since the turn of the decade the proportion of the Irish market owned by Irish institutions has fallen from 25 per cent to 15 per cent at present, although the proportion owned by Irish retail investors has remained broadly unchanged in the high teens.

The proportion of the market which is held by non Irish institutions has now risen to close on 60 per cent. Almost half of that percentage is held in the United States, with the remainder broadly spread between the UK and Europe.

But there has not just been a change in the geographic ownership of the market but in the nature of the funds who are the underlying holders, although it is difficult to get precise data on the trends. By this we mean the emergence of hedge funds as serious participants alongside the traditional long only value funds.

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