Liquidity – little understood, even before MiFID II

01 Jan 2018 / Insight

By Keith Hiscock, Yingheng Chen

Liquidity is the lifeblood of a market and one key reason to list on a stock market. The coming into force of MiFID II in January 2018 is expected to result in a collapse in the commission ‘pot’, making it uncommercial for brokers to write research about most small and mid-cap stocks. Dramatically less research and weaker distribution is going to hit liquidity. Yet even before the revolution that is MiFID II hits, low liquidity is the ‘hidden issue’ that most managements have not been told about or grasped, and whose implications cannot be ignored any longer. This paper explores the reality of liquidity. It concludes that AIM companies with market capitalisations below £700m, and Main Market companies smaller than £500m, should not expect anyone other than the house broker, and a paid-for research house such as Hardman, if they engage one, to cover them after January 2018.

Private companies go public for two reasons. First, they may want to raise money to pursue their growth ambitions and, secondly, they want to make it easier for existing shareholders to trade in their shares; of course, knowing that there will be a secondary market after a fundraising reassures investors who have participated in it. The key to both is liquidity which is, after all, the essence of a ‘market’. A market without goods or services changing hands, i.e. liquidity, is not a genuine market.

Larger investors, in particular, are interested in liquidity because, the greater the liquidity in a particular company, the easier it is to build up a position or dispose of one. Indeed, most large institutions use a liquidity filter to judge whether they should even bother considering a stock for their portfolio.

Information on companies is critical to liquidity, with research playing a key role. Good research helps investors to understand the financial levers in a business and the factors which are critical to its success; real analysis then makes assumptions about these factors in the future to produce forecasts. Furthermore, proper research puts a company into an investment context, finding relevantpeers and considering how investors view these peers to help assess the company in question.

There are two challenges for companies and investors to contemplate. First, institutional brokers need a commercial case to write research and secondly companies are often unaware (though investors certainly are) of how limited a broker’s distribution actually is. After MiFID II’s introduction (January 2018), the economics of running an institutional broker will fundamentally change as will their ability to distribute research. As a result, most quoted companies will see the number of analysts following them shrink dramatically and the audience brokers reach contract as well.

Combining our model of a broker’s research department with our analysis of market liquidity we believe that few companies with market caps below £700m on AIM or £500m on the Main Market will have ANYONE other than the house broker, or a paid-for research house such as Hardman, covering them. In the post MiFID II research environment, companies should be aware of the commission ‘pot’ that trading in their shares generates, because it will explain how many brokers, if any other than the house one, they can realistically expect to cover them. Our modelling in the aforementioned paper, suggested that, just to break even, an institutional broker needs to generate £30,000 commission a year in every non-house stock it covers. The data presented here about the commission generated will come as a shock to many managements.

For some years now, Hardman has maintained its own database, constructed from London Stock Exchange data, to help individual companies understand issues around their liquidity and to identify the best target investor audiences. Our database contains the details for trade size and commission for every quoted company over every period and is used to compare each company with a peer group of similarly sized companies or other companies in the same sector. PLC boards wishing to understand their own situation – and the MiFID II induced changed environment -are welcome to request this data.

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