Privatizations show where value lies

The recent privatizations and share buybacks of Sime Darby and Hongkong Land show that someone thinks it is time to start buying.

There are two types of privatizations in the capital markets: one where governments flog former nationalized companies and one where publicly traded companies buy back their shares and go private. Both keep equity investment bankers busy and lawyers rich, but there the similarity ends.

In Asia we have for years been hearing about the first form of privatization as bankers, lawyers, regulators and pundits call on governments to sell their assets. Yet in the last few weeks we have begun to hear a lot more about the second form of privatization.

Share buybacks - another term for this exercise - are becoming increasingly common. Interestingly, it was the Jardine Group and its subsidiaries that started the trend with Jardine Strategic's tender for its own shares back in September. This was followed by Hongkong Land's tender offer to repurchase its shares last week. In the last few days similar offers have come from the Hong Kong and Singapore listed subsidiaries of Malaysia's Sime Darby Berhad (SDB). And a further announcement has come from Ng Fung Hong - the listed subsidiary of China Resources Enterprises.

This sudden outburst of corporate rapaciousness has many reasons behind it and many more to commend it. First and foremost, the companies are buying back their shares because they think they are cheap. In Sime Darby's announcement of its Hong Kong privatization, the company explained "The shares have consistently traded on the Stock Exchange at prices that SDB and the Company [Sime Darby Hong Kong] believe do not reflect the value of the Company."

Although very few CEOs ever believe that stock investors give their companies full value, most are content to just moan into their Cognac about it. When they start putting up serious money - $572 million in Hongkong Land's case, $142 million in Sime Darby's case - it shows that it is a very important exercise in corporate finance.

The accountants and analysts will point to the fact that by buying back shares and cancelling them, there are fewer shares to go round and so earnings for each share will increase. This works best in an environment where earnings are increasing at a greater percentage than the percentage of shares being bought back. So a share buyback exercise is usually an indication that the CEO knows there are some good earnings around the corner which public investors don't seem to be factoring into the share price.

Free-floating world

It also points to other trends in the market. The two subsidiaries of Sime Darby had free floats of between 25% and 30% each. For many investors that is too small because of the advent of free float weighted indices. In this world companies are valued according to their weighting in the indices that global fund managers have to track.

Many companies get very upset when other companies are valued on higher multiples for reasons other than their profit growth potential. If companies get higher valuations by dint of being in an index, then that is a fundamental fault of the system. Companies should be valued on their ability to grow profits and extend shareholder value, not on the whim of some index committee which deems one sector more important than another.

Further structural flaws in the financial system could be the cause of the increasing trend in privatizations and buybacks. The Sime Darby buybacks are the result of the consolidation in the investment banking business. As the number of investment banks dwindles, and even fewer are willing to give wide research coverage to non-index companies, so investor attention is focused on an increasingly small number of stocks.

Sime Darby Hong Kong does not appear to be one of those companies. In its announcement the company says "the level of analysis and coverage from market research professionals has been slight, contributing to the low level of investor attention to the company's merits." This is a frank admission of how important positive analyst coverage is these days.

Furthermore, it is apparent that companies no longer need the public markets to raise capital. Strategic stake sales are increasingly prevalent in Asia, as international and local companies seek to buy into other companies for investment purposes. The issue of control comes up occasionally, but the vast majority of M&A deals in the past few years have been strategic deals for small portions of the target company. These deals fall into a sort of no man's land between equity capital markets transactions and outright M&A. Indeed they are an indication of how the traditional split between institutional and strategic investors is no longer valid, and banks that fail to realize this are failing to serve their clients.

What these buybacks are telling us is that the public markets do not value every company in the same way. Huge and lasting disparities exist in the valuations, the volatility and the methodology. And many corporate executives are getting a little bit tired of it. This is ironic because a public listing is meant to ensure transparency, honesty and a level playing field for all shareholders. In fact it is producing an entirely un-level playing field for the companies that are listed.

Expect more privatizations as companies take advantage of structural flaws in the financial system to increase their returns to shareholders and improve their profitability. In the long run, index managers might just lose out.

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