Capital Market Activity and the Growth / Value Divide

The valuation divide that has been establishing itself between European and US stocks is also being reflected in each region’s equity capital markets activity. What’s clear is that US investor appetite to digest deals remains near-insatiable, with extraordinary IPO performance. In Europe, there simply isn’t the depth of demand to sustain the secondary markets once deals have launched. The growth/value paradigm has always been a discussion about inflation. The question now is when, and if, inflation will finally kick in. If it does, we might see renewed interest in both Europe and value stocks. And we may look back on some of 2018’s IPOs with the same kind of horror we remember Pets.com, CIT or Webvan.

25 OCTOBER 2018

We’ve written before of the increasing valuation divide that has been establishing itself between European and US stocks. This bifurcation is reflected in each region’s equity capital markets activity, whose very different paths are, we think, worthy of further discussion.

The headline facts are unsurprising. The US is booming, both in terms of the value of initial public offerings (‘IPOs’) and the secondary placement of follow-on blocks of equity, while Europe’s numbers are less stellar. It is in the detail, though, that the real interest lies, and it is here that we are able to draw broader conclusions about the fate of each respective market.

Turning to Europe first, IPO volumes were at a relatively healthy USD31 billion this year through to July 101. This is less than the US – which stood at USD42.5 billion this year through July 311 – but not dramatically so. What’s more, European volumes are 16% higher than the same period last year, suggesting that things may not be as bleak as we might expect. Once you start drilling down into the numbers, though, a different picture reveals itself.

Figure 1. EMEA IPO Renaissance

Source: Dealogic; As of July 10, 2018.

Europe has been dominated by a few big deals. Once again, the make-up of the European market is driving pricing. While there was some issuance in the technology and healthcare sectors, the landscape is still dominated by slower-growing old economy firms. The majority of other issuance came from financials, telecoms and real estate2 – industries which are currently out of favour globally and particularly unloved in Europe.

Aston Martin is the latest European firm to approach the market, with an offering that initially sought to establish a valuation of USD5 billion. The shares ended up pricing at the lower end of estimates – at GBP19 having initially guided GPB17.50-22.50 – and fell as low as GBP17.75 on its first day of trading before ending at GBP18.103. This experience is symptomatic of IPO issuance in Europe, where deals generally tend to get priced with greater discounts and have recently underwhelmed in the secondary market.

It’s here in the post-issue trading that the real difference between the US and Europe becomes apparent. While the absolute IPO issuance numbers may not be wildly divergent, secondary market appetite and performance are worlds apart.

Firstly, the absolute amount of follow-on trading – large blocks of equity sold in the wake of an IPO – has fallen precipitously in Europe, down almost 40% to USD77 billion this year through to July 10 (Figure 1). In the US, this figure is USD119 billion through to July 31, down only about 8%, according to Dealogic.

What’s clear is that US investor appetite to digest deals remains near-insatiable, with extraordinary IPO performance – 20% of deals this year to the end of September have priced above the initial range and the average first-day trading has seen stocks rise 15% – and then consistent and predictable interest subsequently, according to CMG. In Europe, there simply isn’t the depth of demand to sustain the secondary markets once deals have launched.

One of the key factors here has been the gradually changing face of investors in European markets. It was previously the case that US investors would take up a sizeable chunk of European issuance. Since Europe’s markets began underperforming the US, driven by the perception of heightened political risk and the scarcity of technology and other growth stocks in the region, US investors have been notable by their absence. What’s more, trading around IPOs is increasingly dominated by quantitative deal players. These are not fundamentally driven investors who will support the stock over the long-term, but rather traders whose risk limits are usually far tighter than their buy-and-hold peers.

Closer scrutiny of the performance of European IPOs uncovers a number of illuminating details. On the first day of trading, the average return of an IPO stock has been 7% this year through to end-July, according to Dealogic – a figure that appears relatively decent given the travails of the broader market.

However, this statistic hides the extraordinary dispersal of returns around this mean. What becomes clear is the enormous appetite that remains in Europe for firms exhibiting growth, and particularly for those in the technology sector. As an example, Adyen, an online payments company, launched to the market in June and traded up a staggering 95% on the first day of trading. There were other notably positive debuts from a host of tech-related firms, including Sensirion – a maker of digital micro-sensors – and Netcompany – a Danish service provider.

What this does is it takes us back to the old growth/value divide. As Figure 2 shows, the MSCI World value versus growth metric is trading near its lows.

Figure 2. MSCI World Value Versus Growth

Source: Goldman Sachs; As of September 13, 2018.

As Figure 3 illustrates, the European market is dominated by value stocks at a time when investor demand globally is skewed toward growth.

Figure 3. More Growth Companies in US Than Europe

Source: Goldman Sachs; As of September 13, 2018.

Many of the firms that dramatically underperformed post-IPO in Europe were what we would consider value stocks – old economy firms with real assets paying high dividends. The five worst-performing post-launch IPOs of the year so far have been in logistics, real estate and financial services.

Many have compared the current ebullience surrounding tech stocks to the mania of the dot com bubble. So far, there’s a key difference – earnings. Investors haven’t been asked to rely on the promise of profitability further down the line, but are buying into tech stocks at a time when these companies are exhibiting a proven ability to deliver consistent and often double-digit earnings growth.

This is changing, however. What has become clear is that the success of the FAANG stocks has paved the way for the return of a more optimism-driven form of investing. Tech now is more profitable than it was in the last bubble, but only marginally so. Indeed, 19% of listed US tech firms are currently turning a profit, versus 14% in 2000, according to data compiled through September 30 this year by University of Florida finance professor Jay Ritter. However, of all IPOs launched in the US so far this year, 83% are loss-making companies, a figure that surpasses even the wild confidence of 2000 (Figure 4).

Figure 4. US-Listed IPOS That Were Loss-Making on Track to Beat 2000 High

Source: Jay Ritter. Note: 2018 is through September 30.

The growth/value paradigm has always been a discussion about inflation. Think back to the first weeks of Donald Trump’s presidency, when the market’s initial reaction was to buy value. It was thought that Trump’s championing of old economy industries and his protectionism would see a rise in inflation, meaning that investors should favour value stocks. It wasn’t an irrational decision; it was just a question of timing.

In the face of the vast wall of liquidity that quantitative easing delivered, everything has just taken longer to feed through. The question now is when, and if, inflation will finally kick in. If it does, we might see renewed interest in both Europe and value stocks. And we may look back on some of 2018’s IPOs with the same kind of horror we remember Pets.com, CIT or Webvan.

1. Source: Dealogic.
2. Source: CMG, Citi July ECM overview report, Barclays August ECM overview report.
3. Source: Bloomberg.

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