Shrinking JSE puts investor returns at risk

Companies continue to delist from the Johannesburg Stock Exchange (JSE), shrinking the investment universe for South Africans.

The lower number of shares crowds out active fund managers and puts investors’ returns at risk, particularly the ability to earn outsized returns.  

This is feedback from the head of investments at Morningstar South Africa, Sean Neethling, who said the delisting trend has raised concerns about the future of investing in local equities. 

“The shortage of new listings, the relatively weak performance of local shares and depressed levels of business confidence have further exacerbated fears among market participants,” he said. 

The number of listed companies has reduced by almost half since 2002, with less than 300 listed today. It can also be seen in the market capitalisation of the JSE. 

The graph below shows new listings have dropped off significantly since 2002, while de-listings have averaged more than 10 per year over the same period. 

South Africa is also not unique, with net listings in developed European and UK markets also trending downwards. 

Delistings should be considered a normal part of the economic cycle and are not necessarily negative events, especially where private markets are better at unlocking shareholder value.

Delistings may unlock value in a way the traditional market mechanism failed to. For more active managers, identifying companies likely to be acquired at a premium to the current share price could potentially be a secondary part of the investment thesis.

Delistings may also improve market integrity. It could be argued that companies with less robust business models should not be listed in the first place. 

The incentive for companies to list is to unlock shareholder value through access to a wider pool of investors.

However, the purpose of publicly listed markets is to create long-term shareholder wealth, not incubate companies that should be privately owned. 

Neethling’s central concern is the level of market concentration and its impact on investment portfolios. The JSE is highly concentrated, with the Top 40 shares accounting for approximately 85% of the index. 

Delistings have had minimal impact on JSE trading and liquidity, given the high levels of index concentration and size of the main index constituents.

The direct impact of smaller companies exiting the market is minimal to large asset managers or investors as most were not core holdings in major benchmarks or the index. 

Approximately 70% of de-listings over the last five years would be categorised as small-cap or fledgling companies with market caps of less than R300 million, placing them largely outside the investable universe of fund managers and the index. 

Thus, domestic equity funds holding most pension and retirement assets have remained relatively unaffected by the shrinking opportunity set. 

However, a narrower market spells trouble for active asset management as it limits the universe of opportunities to generate returns greater than the index. 

This is particularly worrisome for investors focusing on small and mid-cap domestic equities, as these kinds of businesses may not be listed in the future. 

These companies also trade with relatively less liquidity than the larger companies that make up the index and may take longer to attract the level of investor demand to generate expected returns.

Domestic small and mid-cap companies delivered exceptional returns in the two years following pandemic market lows and do provide a differentiated payoff profile to larger index constituents. 

An acceleration of de-listings into more of these companies will limit the ability of more active managers to deliver outsized returns over time.

A continuously shrinking local investment universe will only serve to increase market concentration. 

Too much money ends up chasing too few investable opportunities, which contributes to companies trading at inflated prices relative to fundamentals, Neethling warned. 

At extremes, these companies become “too big to fail”, given ownership in retirement and pension savings pools. 

Market concentration forces managers to seek more diversified investment ideas that may potentially be outside their circle of competence, risking returns. 

The solution to this for South African investors is to look offshore for more investment opportunities, particularly in sectors and companies you cannot get exposure to on the JSE. 

Fund managers seeking diversified exposure should widen their investable universe by allocating to different countries, sectors and currencies.