Smith s is an independent corporate finance advisory firm whose advice is built on a continuing dialogue with institutional investors.

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3 Smith s is an independent corporate finance advisory firm whose advice is built on a continuing dialogue with institutional investors. Contents: Introduction Page 4 Conclusion Page 6 Synopsis of results Stock performance Page 9 Comparative valuation Page 10 Comparative trading volumes Page 11 Comparative stock volatility Page 12 Impact of market turmoil in Q3/Q4 08 Page 13 Period between announcement and implementation Page 14 Process Page 16 Full list of companies Page 18 Contact Page 19

4 Introduction 4

5 The purpose of this study is to ascertain what, if any, effects on share price performance occur when a company enters or leaves the FTSE 100. Trading and fundamental data for the companies involved in the FTSE quarterly reshuffles is analysed for the effects on a number of parameters. Inclusions in the FTSE 100 that have occurred in between the quarterly reshuffles, typically as a result of a delisting by a constituent, are not included in the analysis. The timeline for the reshuffle is: An announcement of which companies are coming into and exiting the FTSE 100 takes place on a Wednesday in March, June, September and December. The first period for analysis is the two months running up to the announcement. There is a subsequent gap of seven trading days before these changes are implemented, which takes place after close of trading on a Friday. Market participants can use this interval to begin to implement whatever changes are required in their portfolios. This will be particularly relevant for index (passive) funds and those that are benchmarked against the index. The changes become effective, therefore, from the following Monday i.e. seven trading days after the announcement. The second period of analysis is the two months subsequent to that Monday. Period for analysis: Data from the two periods for each company is then compared. The interim period over the seven trading days between announcement and implementation is also reviewed and compared against the other periods to ascertain its significance. The parameters analysed are: Stock price returns Stock price volatility Trading volumes Stock valuations (Price/Sales ratio) n.b. the exact methodology is outlined in more detail in the chapter Process on page 17. 5

6 Causes Conclusion of Volatility Change Narrowing Earnings Expectation Bracket The downward trend in Peter Hambro s volatility is largely due to consistency in meeting and beating earnings expectations. The volatility decreases as the market gains confidence in the management s earnings predictions. The steep drop in volatility seen in September 2003 came after first half profits were reported to have more than doubled from the previous year after expansion of production at the Pokrovskiy mine. The company later announced that it had won the licenses for Voroshilovskye deposit and the Malomir surround with over 3 million ounces of reserves. Full year results in April 2004 exceeded expectations and costs appeared tightly controlled. In early September 2004 the company announced it expected to meet full year targets, but first half profit declined as costs rose and it lowered output forecasts. In October production capacity at Pokrovskiy was boosted by a third after completion of an ore treatment plant. The rise in volatility from November came after the unexpected cancellation of plans to buy a deposit in far east Russia, although this purchase did go ahead in the following June. Fig 9 & Fig 10: PER (12 months forward earnings) relative to Stoxx Basic Resources sector PER against relative volatility and share price relative to sector (rebased to 100) Source: EcoWin, Longview Economics, Smith s Peter Hambro s stock has been consistently rerated over this period and out performed its sector. This has largely been the result of management s ability to exceed expectations and through increased production, to take advantage of higher bullion prices. It is perhaps interesting to note that relative volatility had a strong relationship with relative PER over this period, while forward earnings expectations and earnings momentum did not. This would imply that the market was more concerned or impressed with the reduction in risk associated with Peter Hambro, through meeting and beating expectations, rather than in the exact level of earnings or earnings growth. Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec H1 profit disappoints 0.7 and forecast lowered Full year production 0.9 targets to be met Buys gold deposit in far east Russia H1 net profit more than doubled Fig 1 6 6

7 Coming into and remaining in the FTSE 100 has demonstrable benefits: Stocks tended to trade at a significant premium in the FTSE 100 compared with when they were in the FTSE 250. Valuations were at a premium of c10% two months after promotion to the FTSE 100, compared with valuations two months ahead of the announcement when they were in the FTSE 250, on average. When companies fell into the FTSE 250 the premium on valuations two months ahead of the announcement when in the FTSE 100 was greater again and was c21%, compared with valuations two months post the change. Therefore, the de-rating that occurs when companies exit the FTSE 100, is greater than the re-rating that takes place when entering it. This implies that the premium associated with membership of the FTSE 100 increases for companies that retain that membership and/or stocks exiting the FTSE 100 are penalised to a degree that is greater than the extent to which those entering it are rewarded. FTSE 100 stocks, going into the FTSE 250, had greater liquidity than those in the FTSE 250 that were coming into the FTSE 100. Increased liquidity can lead to a virtuous circle of increased attraction as a potential investment, greater demand, increased buying/selling, increased liquidity, etc. It can be seen that remaining at the fringe of the FTSE 100 and repeatedly entering and exiting the index will lead to increased volatility over a longer time frame and that, subsequently, a stock may de-rate versus its peers. A case study of Tate & Lyle PLC, which exited and entered the FTSE 100 five times in a fifteen month period, demonstrates that the stock traded at a significant discount to its peers during that time. There is a greater level of trading, on average, ahead of the announcement of which stocks are leaving the FTSE 100 than in the intervening period between the announcement and the implementation of those changes. This is in contrast to the stocks coming into the FTSE 100, which experience a greater level of trading in the interim period. The implication from this is that the indexed and benchmarked funds may not wait for the announcement of which companies are leaving the FTSE 100 to begin reducing their holdings. As a consequence, newsflow-driven price weakness may be being exacerbated by portfolio repositioning and the drop in market sentiment towards these stocks can become self-fulfilling. It is clearly worth management s time to adopt a pro-active stance in seeking to ensure FTSE 100 status is both achieved and, crucially, maintained. 7

8 Synopsis of results 8

9 Stock performance: FTSE 250 stocks coming into the FTSE 100 experienced average price gains of 13.8% in the two months preceding the announcement. During this time, these stocks also out performed the FTSE 350 by an average 14.7%. Once they had entered the FTSE 100, these stocks then declined marginally (by -1.1%) in the subsequent two month period and under performed the FTSE 350 to a similar degree (by -1.1%). This demonstrates that a stock which is going to be promoted achieves that through out performance, which subsequently levels off post entry to the FTSE 100. Stocks falling out of the FTSE 100 had price falls of 17.5%, on average, in the two months leading up to the announcement. During this time the stocks under performed the FTSE 350 by 16.7%. Once they had entered the FTSE 250, the stock prices then rose by 2.4%, on average, in the following two months and out performed the FTSE 350 by 2.2%. Stocks that are about to fall out of the FTSE 100 do so as a result of under performance, therefore. Stock returns then level off post entry to the FTSE 250. Absolute stock performance Pre announcement Post change Relative stock performance Pre announcement Post change Exiting FTSE % 14.7% Entering FTSE % -1.1% Exiting FTSE % -16.7% Entering FTSE % 2.2% Source: Smith s, Bloomberg ( Relative stock performance measured against FTSE 350 index over comparable periods) 4 9

10 Comparative valuation: Valuation is defined here by the Price/Sales ratio, which removes distortions from very low profits or from losses. During the two months prior to the announcement, companies in the FTSE 250 tended to trade on a valuation that was 2% less than their average valuation during the two months once they had entered the FTSE 100. Given that the same stocks tended to rise by 13.8%, on average, ahead of the announcement and that the returns subsequent to the implementation were relatively flat this implies that the stocks in the FTSE 250 were trading at a discount two months ahead of the announcement compared with their valuation two months after promotion. More notable is that through the two months ahead of the announcement the average valuation for stocks exiting the FTSE 100 was 13% higher than the average valuation in the two months after entering the FTSE 250. This confirms that companies in the FTSE 100 tend to trade on a premium to those in the FTSE 250. It is also intuitive that a stock s valuation would have been higher ahead of a period of poor returns i.e. before the stock price fell by 17.5%. Gauging the exact degree of the premium/discount ahead of the announcements is not straightforward, but can be estimated by reviewing the relative valuations two months ahead of the announcement compared with two months after the changes became effective i.e. at the start and end of the relevant periods for measurement. In this instance, companies that left the FTSE 250 were at a 10% discount two months before the announcement compared with their valuations two months after entering the FTSE 100. Conversely, companies that left the FTSE 100 were at a 21% premium two months ahead of the announcement compared with their subsequent valuations two months after they had entered the FTSE 250. It is also notable that the medians (values of the middle items) in the distributions of premium/ discounts, when comparing two months ahead of the announcement with two months after effectiveness, are more extreme than the averages. For example, when coming into the FTSE 100 the median discount is 15% and when entering the FTSE 250 the premium on the valuations is 43%. This suggests that stocks in the FTSE 100 could trade on a bigger premium than that implied by the average premium of 21% (when leaving) and 10% (when entering). The de-rating that occurs when companies exit the FTSE 100, on average, is greater than the re-rating that takes place when entering it. This implies that the premium associated with membership of the FTSE 100 increases for companies that retain that membership and/or stocks exiting the FTSE 100 are penalised to a degree that is greater than the extent to which those entering it are rewarded. FTSE 100 status is, therefore, worth fighting for both to achieve and to retain. Premium / Discount Comparing average valuation of each two month period Comparing valuations two months pre and two months post FTSE 250 FTSE 100-2% -10% FTSE 100 FTSE % 21% Source: Smith s, Bloomberg 10

11 Comparative trading volumes: Trading in the stocks was greater ahead of the announcement when both leaving the FTSE 100 (15% greater before being ejected than after) and when entering it (7% greater before entering than after). This is intuitive as fund managers may trade in those stocks that are most likely to enter and exit the FTSE 100 ahead of the announcement. There may also be newsflow that has resulted in the specific out performance or under performance which in turn led to promotion to or exit from the FTSE 100; it is possible that increased trading will be associated with this out performance or under performance. While it is not strictly correct to compare the trading volumes of those companies entering the FTSE 100 with those leaving the index 1, it is not surprising that the average daily trading volumes of those companies in the FTSE 250 and on the cusp of promotion was around 5 million shares, while it was around 8 million shares for those in and leaving the FTSE 100 i.e. liquidity was notably superior in the FTSE 100 than in the FTSE 250. This result supports the premise that there is greater liquidity in the FTSE 100 due to the larger universe of potential investors. Greater liquidity can create a virtuous circle of enhanced appeal as a potential investment, greater demand, increased buying/selling and further increases in liquidity, etc. Average daily trading volumes Pre announcement Post change Pre volumes/post volumes Exiting FTSE million Entering FTSE million FTSE 250 FTSE % Exiting FTSE million Entering FTSE million FTSE 100 FTSE % Source: Smith s, Bloomberg 1: Those companies entering the FTSE 100 will not be exactly the same as the companies leaving it as companies may enter or exit once only and may do so in between the designated quarterly reshuffles, etc 11

12 Comparative stock volatility: Stock volatility is defined here by the average annualised five day standard deviation in daily returns. Volatility increased ahead of the announcement when compared with the subsequent period post the changes when stocks both entered and exited the FTSE 100. Smith s has previously demonstrated (see Professional Investor, March 07, Volatility and valuations ) that an increase in volatility versus that of a peer group will tend to lead to a de-rating in that stock versus its peers, all else being equal. The average volatility was 17% higher before leaving the FTSE 250 for stocks on the way up than after entering the FTSE 100. Additionally, the average volatility ahead of leaving the FTSE 100 was 19% higher than the average volatility in the period post entering the FTSE 250. This data supports the premise that trading and, by extension, volatility increases ahead of the announcement for stocks moving into and out of the FTSE 100. Of course, the data also suggests that volatility is lower post the implemented change and that, by extension, a stock s valuation may re-rate versus those of its peers at that time. However, it could be argued that remaining at the fringe of the FTSE 100 and repeatedly entering and exiting the index will lead to increased volatility over a longer time frame and that, subsequently, a stock may de-rate versus its peers in the long term. At a qualitative level this makes sense as there will be uncertainty associated with a company that repeatedly moves into and out of the FTSE 100 as its status as an investible stock, for many fund managers, will continually alter. For example, Tate & Lyle PLC came into and out of the FTSE 100 at the quarterly reshuffles on five occasions in total from December 07 to March 09, inclusive. Its relative volatility and valuation (Price/ Sales ratio) during that period is shown in the table below. Even though it is not surprising that volatility of an individual stock price is greater than that for the relevant sector index, there will have been little reduction in volatility in the Food Producers index from diversification in this instance as a result of the significant weight within it from a small number of its major constituents. As such, it is significant that the volatility in Tate & Lyle s stock was up to 195% of the volatility of the index in the months of the relevant reshuffles i.e. up to twice as much. The fact that Tate & Lyle traded at a significant discount to its peers during the overall period supports, therefore, the premise that a stock will be de-rated versus its peers if it persistently exits and enters the FTSE 100. Dec-07 Mar-08 Jun-08 Dec-08 Mar-09 Tate & Lyle s volatility relative to volatility of FTSE 350 Food Producers index 176% 195% 187% 185% 166% Average valuation premium/discount to peers from Oct '07 to May '09 Associated British Foods Cadbury Unilever -21% -63% -54% Source: Smith s, Bloomberg n.b. volatility is annualised five day standard deviation in daily returns and is measured from two months ahead of the first reshuffle to two months after the last one; current weightings within FTSE 250 Food Producers index are Unilever PLC: 55%, Cadbury PLC: 26%, Associated British Foods PLC: 8%, Tate & Lyle PLC: 5%, Others: 6% 12

13 Impact of market turmoil in Q3/Q4 08: The impact of the market turmoil on volatility, stock returns and ratings in the third and fourth quarters of 08 is well documented. For example, there was a marked increase in volatility in 08 and into 09 when compared with prior years such as 04. Stocks entering the FTSE 100 had average volatilities of 19.1% and 24.6% in 09 and 08, respectively, after entering the index. By contrast, the volatility was 9.9% in 04. For those stocks leaving the FTSE 100 the difference was even more pronounced; in 09 and 08 the average volatility of stocks whilst still in the index before going down to the FTSE 250, was 21.1% and 32.7%, respectively, compared to just 9.2% in 04. The results were re-run, therefore, excluding the September 08 reshuffle to see if it had distorted the data in any way: Comparison of parameters between two month period pre announcement and two month period post change Entering FTSE 100 Leaving FTSE 100 All reshuffles x Sep 08 All reshuffles x Sep 08 Net absolute stock performance 12.7% 16.0% -15.1% -11.9% Net stock performance relative to FTSE % 15.3% -14.4% -12.3% Relative valuations 1 98% 96% 113% 106% Relative trading volumes 107% 108% 115% 117% Relative stock volatility 117% 121% 120% 122% Source: Smith s, Bloomberg 1: Valuation data for two stocks, around a separate reshuffle in both cases, appears corrupted and is excluded As such, results from the data which excluded the September 08 reshuffle are very similar to those from the whole set. 13

14 Period between announcement and implementation All previous data refers to the two months prior to the quarterly reshuffle announcement and the subsequent two month period after those changes were implemented. There is, as stated, an interim period between announcement and implementation of seven trading days which was excluded as it was expected that most repositioning of portfolios would occur during this time. While it is more relevant to review the longer periods, it is also helpful to gain an understanding of what is happening during these seven days. Stock performance: Upon entering the FTSE 100, post the strong absolute (13.8%) and relative stock performances that resulted in their promotion, stocks made further absolute gains of 1.9% in the interim period i.e. the gains were maintained, albeit at a reduced rate (the average return from the seven day period equates to a gain of c12% when compounded up to a calendar two month period). It is only when the stocks had actually entered the FTSE 100 that the returns, both absolute and relative, became negative. While newsflow that drove the initial gains may have dissipated to some extent by the time of the announcement the funds that needed to buy the stocks for indexing or benchmarking purposes would have done so to a large degree in the interim period, supporting the stock prices. The average return in the interim period when stocks left the FTSE 100 was also positive, at 3.1%, as was the relative return of 2.6%. This would imply that whatever news led to the poor stock performance in the initial two month period had been priced in by then and that most of the funds that needed to sell the stocks from an indexing and benchmarking perspective had done so to a significant degree. However, the average return was skewed upwards by returns in March 03 and March 09; UK equities rose strongly after hitting lows in both of those months. By contrast, the median stock return for this interim period was -1.6%, suggesting continued pressure on stock prices, although at a reduced rate (the compounded median return was c-10% when equated to a two month period). Averages from two months pre anouncement and post change and over seven day interim period Entering FTSE 100 Leaving FTSE 100 Pre annoucement Interim period Post change Pre annoucement Interim period Post change Stock performance 13.8% 1.9% -1.1% -17.5% 3.1% 2.4% Relative stock performance % 1.4% -1.1% -16.7% 2.6% 2.2% Daily trading volumes 5,383,565 5,995,029 5,203,193 8,355,924 7,814,198 7,636,350 Stock volatility 18.0% 18.8% 17.1% 21.2% 21.0% 19.5% Source: Smith s, Bloomberg 1: Relative to FTSE 350 index 14

15 Daily trading volumes: The average daily trading volume for stocks coming into the FTSE 100 rose from c5.38 million, in the two months ahead of the announcement, to c5.99 million in the interim period, before falling back to c5.20 million. The majority of the trading related to indexed and benchmarked funds appears to occur, therefore, during the interim period, notwithstanding the likelihood that some of the repositioning takes place ahead of the announcement when it is clear that a stock will be coming into the FTSE 100. By contrast, the average trading volume was lower in the interim period than in the two months ahead of the announcement for the stocks that were falling out of the FTSE 100; the implication being that either the majority of the indexed and benchmarked funds had repositioned ahead of the announcement or that heavy trading was associated with the negative newsflow which led to the poor stock performances, or a combination of the two. The fact that the average stock return in the interim period is positive, does lend support to the idea that a significant portion of the selling had already occurred by the time the announcements were made, notwithstanding the previously stated caveat concerning March 03 and 09. The greater total of assets under management associated with funds indexed and benchmarked against the FTSE 100 compared with those covering the FTSE 250 will also explain the greater levels of trading throughout the periods of analysis for stocks initially in the FTSE 100. Stock volatility: The stock price volatility data supports, at least to some extent, the idea that most of the trading in stocks coming into the FTSE 100 occurs after the announcement is made but that a significant portion of it takes place before the announcement when stocks fall out. For example, average stock price volatility rose to 18.8% in the interim period, from 18.0%, when stocks came into the FTSE 100 and then subsequently fell to 17.1% post implementation. Average volatility declined marginally, however, to 21.0% in the interim period, from 21.2%, when the stocks fell out of the FTSE 100. Volatility post implementation was also lower in this instance. Stock valuations: The variations in stock valuations when compared with pre announcement and post change were relatively muted, in line with the minor stock returns during the interim period. 15

16 Process 16

17 Trading and fundamental data for the companies involved in the FTSE quarterly reshuffles is analysed for the effects on a number of parameters. The analysis excludes changes in the constituency of the FTSE 100 in the intervening periods between reshuffles. Data is available from September 02 onwards and runs up to and includes data from September 09 and the two month following period. The parameters of Stock returns Stock volatility Trading volumes Stock valuations were measured over a two month period immediately prior to the announcement of which companies were coming in or going out of the FTSE 100, and compared that with the subsequent two month period after implementation had occurred. The two month period for measurement was selected as the reshuffle takes place every three months and if it was longer it might overlap with the next quarterly reshuffle and distort the results. n.b. price/12 month net sales was selected as the valuation parameter as it provides both a long time series and it is not subject to the distortions from actual or forecasted losses that can affect multiples based on earnings The timeline for the implementation of the reshuffling is: The announcement is made on the Wednesday following the first Friday of trading in March, June, September and December. For example, if the 1st of December is a Thursday then the announcement is made the subsequent week on Wednesday 7th, but if the 1st is a Saturday then the announcement is not made until the second week of trading and is on Wednesday 12th. The changes to the FTSE 100 constituents are then implemented after close on the Friday in the subsequent trading week to the announcement. These changes become effective, therefore, from the following Monday i.e. if the announcement was made on Wednesday 7th the implementation occurs after the close on Friday 16th and becomes effective from Monday 19th. Comparable data was also reviewed during the seven trading days between the announcement and implementation to ensure completeness and to understand the significance, or not, of that interim period. 17

18 Full list of companies Source: Press_Packs/uk_review.jsp Key: exit from FTSE 100 entrance to FTSE n.b. where a company exits twice without an apparent entry it will have done so in between the quarterly reshuffles as a result of a FTSE 100 member delisting

19 Contact David Navas, CFA Director - Research navas@smiths-ca.com +44 (0) Smith s Corporate Advisory 20 Northdown Street London N1 9BG +44 (0) Registered Company Number: This material is for information only and for the use of the recipient. It is not to be reproduced or copied or made available to others. Under no circumstances is it to be considered as an offer to sell, or a solicitation to buy any investment referred to in this document. While the information contained herein is from sources believed reliable, we do not represent that it is accurate or complete and it should not be relied upon as such. Any opinions expressed are our present opinions only. In addition, we shall not be responsible for amending, correcting, or updating any information or opinions contained herein. Some of the views expressed in this report are not necessarily those of Smith s Corporate Advisory Limited ( Smith s ) and they do not represent our opinion on the credit-worthiness or investment profile of the company or industries mentioned in this document. We may from time to time have positions in, or options on, and buy and sell securities referred to herein. We may from time to time solicit, or perform services for, any company mentioned in this material. This communication is directed only at market counterparties and intermediate customers within the meaning of the Rule Book of the Financial Services Authority. The investments and/or services to which the communication relates are available only to market counterparties and intermediate customers. Private customers must not make use of this document. Any investment or investment services referred to are not available to such investors from Smith s. This material has been tailored for, and is intended to be for the sole reference of, the addressee. Smith s is authorised and regulated by the Financial Services Authority. 19

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