How to Fix the JSE – SmallCaps.co.za

We cannot fix problems if we cannot be honest enough to admit that they exist. If we are honest with ourselves, there is something deeply wrong with the JSE’s stock market and it appears systemic.

One way to see it is that the JSE’s ecosystem is stuck in a negative feedback loop. Our stock market is getting smaller, more concentrated and less investable. If this is trajectory is not changed, the end-point is that the JSE becomes a zombie market and, ultimately, slips into complete irrelevance on the global stage.

As South Africans, we would all be poorer (pun intended) if that happens.

The Problem: A Negative Feedback Loop

Going back a decade and ignoring derivatives and debt instruments, the JSE has lost a net -71 individual listings across its bourse (Figure 1). This is roughly -13% of its entire equity universe and implies that the number of listed investment options for investors on our equity market has been shrinking by -1.2% y/y.

When you consider that the stock exchange’s largest stocks have been unaffected (the Top 40 Index still has forty stocks in it) and that there has been a raft of unbundlings on the market (e.g. Prosus, Motus, Tsogo Hotels, and so on), these figures look even worse. (An unbundling was already listed in the first place, hence, is it really a new listing? The honest answer is no.) Excluding the identified unbundlings and the Top 40 Index, the rest of the market (i.e. South African-focussed small and mid caps) has seen individual listings shrink by some -17% in a decade or -1.7% y/y and, arguably, this decline is picking up pace.

The trend of shrinking listings is not unique to the JSE and, indeed, the number of listed stocks across global exchanges has been falling. For example, in the U.S., since 1976 the number of listed stocks has shrunk by around a quarter or c.-0.7% y/y. These figures look even harsher when viewed from the mid-1990s and reflect two major global headwinds against being a listed public company:

Staying private longer: Private equity markets are ever more sophisticated, well-capitalized and increasing do not need to use IPOs and public markets to exit investments, &
Cost of being listed is rising: Regulation, compliance and governance burdens on listed companies have been steadily rising. This burden is disproportionately harsher on smaller listings (see later).

The first point is moot in South Africa because we have a materially smaller and less capitalized private equity sector. But the second point is certainly true (Figure 3). Unfortunately, South Africa has a third point adding to this headwind: sovereign risk.

Unlike the U.S. with the reserve currency of the world, South Africa is an Emerging Market (EM) and a relatively fragile one at that. It is harder to track the capital flows of individual South African investors who pull their money off the JSE and send it offshore. Despite this, we can track the capital flows of non-resident investors in our market and we will consider this a good proxy for all competing capital flows.

Over the last 30 years, foreign investors’ cumulative capital invested on the JSE is now nearly net-zero (Figure 2 – Net c.R28.4bn or fourteen times lower than its peak in 2010). While initially supporting our market, the last half-decade has seen a massive shift into net selling by foreigners and, ultimately, seeing this capital pulled back offshore. (We can consider domestic investor capital flows to at least parallel this with one key exception: once a domestic investor sends his money offshore there is an almost zero chance that they will ever bring it back onshore.)

In other words (and oversimplifying matters), the negative feedback loop on the JSE is as follows:

Investors sell stocks on the JSE to buy more attractive investments elsewhere, &
Capital flows out of South Africa (in many cases it will never flow back into the ecosystem), &
Therefore, our stocks see lower valuations (i.e. not rewarding shareholders for being listed), &
Higher (relative) costs associated with being listed (i.e. penalizing shareholders for being listed), &
Thus, stocks either do not list (here) or, eventually, delist, &
Therefore, our market becomes less attractive to investors, &
Return to Step (1).

There are many flaws in the above analysis. Any complex open-system is hard to unpack concisely into neat lines of cause-and-effect.

For example, the JSE is subject to the macro-vagaries of South African and, indeed, the world. Specifically, the JSE’s investability is directly impacted by South Africa’s investability (which are in turn negatively impacted on by the inefficient public sector, its bloated public sector wage bill, unsustainable debt trajectory, risky Eskom and restrictive labour laws). Likewise, the flows on and off the JSE are directly impacted by sentiment around EMs and risk-on/risk-off trades. None of these problems can be solved by the JSE alone and we need to be cognizant of that.

Despite this, there are some problems that the JSE can control and we should expect them to address these.

The Solution: (Cheaply) Kickstart a Positive Feedback Loop

Joburg Depositary Receipts (JDR) – Solving Problems (1) & (2)

“If the mountain will not come to Muhammad, then Muhammad must go to the mountain.” –Francis Bacon

The first part of the solution is to ignore South Africa and ensure that the JSE holds attractive investments that keep as much capital on its bourse and within its ecosystem (and, thus, South Africa).

What I mean by this is if domestic (or even foreign) investors can buy what they want to buy on the JSE, then why would they go through the bother of selling, withdrawing funds and sending the capital offshore? Buying and selling forex attracts spread and brokerage costs, may introduce taxes and/or create liquidity problems. Thus, if money can be kept where it is (i.e. on the JSE), then this will take the first prize from both an investor perspective and from the JSE’s.

In other words, make sure that capital never has an excuse to leave the JSE, even if it is not invested in South African companies.

While the JSE could go and pitch listings to Alphabet, Apple, Amazon, Facebook, Tesla, Microsoft and other popular global majors, why would these companies want to list here?

Luckily, there is a way to list a company without its permission. In the U.S. they call these “American Depositary Receipts (ADR)” and they involve a global bank buying a large line of script on one exchange, writing a note attaching to this script and listing that note on another exchange where it can be traded based on its underlying (i.e. the script listed elsewhere).

The JSE should write up some simple listing requirements for a so-called Joburg Depositary Receipt (JDR) and then put in place incentives for major global banks to list them here. Maybe the JSE pays the banks to list these notes here (instead of charging them) or it splits the brokerage more favourably with them (or both).

The point being, if Alphabet, Apple, Amazon, Facebook, Tesla and Microsoft were all listed on the JSE via liquid JDR’s, then what incentive would the average investor have to pull his capital out of the JSE, incur costs and admin to send it offshore into an offshore brokerage account only to buy the same stocks that he could buy here?

In other words, JDR’s would keep the capital on the JSE and in JSE-stockbrokerage accounts. Because of this fact, this capital would hopefully then one day trade out of these JDR’s and back into our local stocks.

Hence, the JSE should set up and drive a deep, wide and rich JDR opportunity set with major global stocks. And, no, the JSE should not aim to make money from this. If anything, the JSE should be writing cheques to the banks to manage the JDRs and hope that this keeps the capital within the ecosystem (in which case, in the longer-term, it will earn off of the capital anyway).

Free Real-time Data – Solving Problem (1)

“An investment in knowledge pays the best interest.” –Benjamin Franklin

Costs can create barriers to entry. The higher the cost, the higher the barrier. This is both true of listed companies and the smallest of retail investors. In some ways, if you solve the problem of costs, you solve for liquidity and attract more capital, and, therefore, solve the JSE’s decline into oblivion.

A largely hidden—though quite real—cost in the stock market is that of data. How can you invest or trade in any stock market without access to share prices, market depths and other data? Simple: you cannot. And, therefore, data revenues from the JSE are inelastic and used as a large source of high-margin income.

In the JSE’s H1:20 results, the Group generated R152m of revenue from “Market data fees” against a total of R1.2bn. Revenue from who? That is simple: all of us that use it.

The reality of stock market data is that it is inelastic. Stock exchanges around the world use it as a high-margin revenue stream that we could argue experiences price gouging and above-inflationary increases. Yet investors pay for it because they have no alternative.

Does the JSE do this too?

Figure 3 shows that the money the JSE has generated from selling just pure market data has not just been growing (+17% in H1:20) but that it has been growing faster than the Group’s other aggregate revenues. In fact, for the decade ended of 2019, sales of market data had grown its revenues by +8.4% y/y CAGR, well ahead of the rest of the Group’s revenues that only grew +5.4% y/y CAGR. Given that access to data is a prerequisite to participating in the stock market, the above facts and Figure 3 imply that it has steadily become more and more expensive to invest your capital on the JSE. Given that data is largely a fixed cost, I would argue that this creates a disproportionate barrier to entry for the small investor and plays into the hands of the larger ones by keeping competition out of the market.

The above analysis sets the scene for one of my more subtle solutions: make JSE market data free.

By making real-time data free, you lower the barriers to entry for small retail investors. If not directly, then indirectly as stockbrokers pass these savings on (and they will as the brokerage market is intensely competitive). By lowering these barriers to entry, you get more investors entering the JSE and they bring more capital and more liquidity and it all enters the JSE’s ecosystem. More capital would attract more listings, and so positive momentum would be added to a virtuous positive feedback loop.

If it is this easy, why has the JSE not already made data free? Well, if we assume that market data fees have no (material) costs, then the fees (after tax) are equivalent to profits. If we take these and compare them to the JSE’s total profits, then profits from selling market data made up a whopping 27.1% of the JSE’s FY 19 profit!

While in the long-term I would argue that a positive feedback loop on the JSE would see it growing its profits more sustainably, I acknowledge that giving up nearly a third of anyone’s profits may be too painful for the executives to do.

A solution to this problem might be to make real-time data free only to retail brokerage accounts. In other words, the exchange still generates a fair amount of revenue from other data sales (e.g. to Bloomberg & institutions), but it removes the burden of these costs from the proverbial man-in-the-street.

Finally, it is worth noting that freeing (or lowering the cost) of data induces more participants that will increase the number of trades through the market—both long and short—and, therefore, actually generate higher brokerage and therefore higher revenues in the JSE’s ecosystem.

Lower the Costs of Being Listed – Solving Problem (4)

“Good people do not need laws to tell them to act responsibly, while bad people will find a way around the law.” –Plato

The temptation is to lower the JSE’s listing fees but this would miss the point. The JSE’s actual listing fees are relatively low (see them here and see a further range here) and are only a small percentage of the total cost of being listed.

For example, the JSE charges a company with a market cap of over R50bn a once-off Main Board listing fee of R3.6m or c.0.0072% of its market cap. I would argue that might even be too little. It is not that much more expensive for smaller listing either with the most expensive one being c.0.32% of its size.

So why is listing so expensive?

It is everything else that costs companies and, ultimately, investors so much money.

One executive told me that they thought their listing cost them about R5m worth annual costs, from management time & effort to governance & non-executive fees to advisors’ & lawyers’ fees. It is worth noting that their annual listing fee to the JSE would only be around R52,424. Thus, their annual cost of being listed was nearly a hundred times the fees earned by the JSE!

The solution to this problem is not the JSE charging listed companies less, but rather the JSE cleverly changing the rules while not sacrificing much on the quality of governance across its bourse.

I acknowledge that it is deeply unpopular to push for less regulation and lower governance but is it really fair that the smallest of the small stock on the JSE Main Board has the exactly same rules applied to it that the largest of the global, multi-nationals do? Is this not regressive in nature?

Should Adcock Ingram Holdings Ltd that is ten times smaller than Aspen Pharmacare Holdings Ltd be subject to the same onerous rules? Does it help or hinder Orion Minerals Ltd to have to comply to the same rules that Anglo American Plc does, particularly when Orion Minerals is over four hundred times smaller? Is it right that the same expensive rules are applied to AH-Vest Ltd that are applied to Tiger Brands, especially when the latter is nearly four thousand times larger than AH-Vest?

Onerous and expensive listing rules are effectively a regressive penalty on a company’s size. The smaller the company, the more expensive these rules become (proportionally) and, thus, discourage growth, innovation and ultimately competition while erecting a barrier to entry around large, entrenched groups.

Let me remind you that governance rules were not enough to stop Steinhoff happening, nor Tongaat Hulett, nor African Bank. Governance will not save you from fraudulent companies and dishonest management. What onerous governance will do is penalize the honest (smaller) companies that comply with it (at great cost) irrespective of the fact that they would have been run honestly without it.

I suggest two broad things here:

Lower the more onerous governance requirements for non-large cap stocks – I.e. Make the listing rules progressive and related to size.
Create a (non-conflicted) central service by the JSE offering some basic services cheaply:
1. JSE “house” company secretarial services,
1. JSE “house” independent non-executives on retainer,
1. SENS compilation department, &
1. IFRS guidance services.
1. Any other basic governance services that do not breach the JSE’s mandate.

The first point will lower the cost to small companies of being listed and, thus, give them a fighting chance to at becoming large companies. At the point when they are larger, they will become subject to the same rules as the biggest of the big companies and, thus, governance standards across the market cap weighted JSE will remain relatively high.

The second point is trying to create “returns to scale” for some standard costs across listed companies and it could even be profitable for the JSE to do so.

For example, imagine the JSE hired a couple lawyers whose sole job was to offer JSE-listed companies a cheap secretarial service. The JSE would be selling these lawyers’ hours at a mark-up and probably could undercut a range of existing services out there in such a way that listed companies could save money.

Surely this would be a win-win for all involved.

Once again, if you lower the costs of being listed, you will get more listed companies. As a discretionary action, listing is an elastic service and it is worth dwelling on this fact.

A Pooled Small Cap Sell-side Research Fund – Solve Problem (3)

Most (sell-side) analysts sit at brokerages and their research is paid for or monetized via trade at their employing brokerage. Therefore, the economics of analyst coverage incentive analysts to cover larger and—importantly—more liquid stocks and avoid smaller caps as they would get less money for the same amount of research.

Unfortunately, these smaller companies are the ones that desperately require coverage and exposure. While most people know what most large cap stocks do without any research, the same cannot be said of the small and mid cap market on the JSE. Hence, many of these smaller listings feel like they have been orphaned by the investment community and slip into oblivion in the listed environment.

There is a solution that would both shine a light on the part of the JSE that is the most affected by the shrinkage and solve the regressive economics of sell-side coverage. This solution is for the JSE to set up a research fund to (part) sponsor small cap coverage.

Here is a suggested set of rules for how this fund (‘the Fund’) would work:

Who: Only research published by analysts employed by registered Financial Services Providers (FSPs) would qualify for an allocation from the Fund.
What: All research on stocks outside of the JSE’s Top 40 (or even, Top 100) qualify for inclusion here. A minimum spec of what qualifies as “research” should be written up (e.g. including a description of the business, forecast, valuation, & other notable elements of good quality research). Published research does not need to be submitted, but only submitted research will qualify and only once it includes all necessary elements. All submitted research published by qualifying analysts will be subject to the Fund’s allocation.
When: Once a quarter an independent board meets to analyse the research submitted to it. This board will then take an allocated budget and allocate out payment to the FSPs employing the said analysts and, thus, help monetize it.
What next: After each quarterly board meeting and allocation have been paid, all submitted research is uploaded to an independent website and made freely available to the public, thus spreading the coverage and exposure wide and far while still giving the producing FSP/analyst some time advantage to distribute it to their clients first.

Further criteria could even include bonus points for affirmative analysts or specific under-covered sectors or dealing with controversial topics.

If the above sounds crazy then consider the following simple workings:

If the JSE allocated R10m per year to this Fund that would be less than 1.5% of annual net profit. (To put R10m into context, in H1:20 the JSE paid executives R17m alone in “committee changes, including restraint payments” and its leave pay provision rose by R11m!)
Yet, an R10m per year allocation to this Fund could fully support nearly 28 individual sell-side analysts earning R30,000 per month!
If each analyst generates one report a month, the JSE would have supported the research on 336 individual stocks or, basically, the entire small cap sector on the JSE.
And the entire public would be able to access this research (perhaps one quarter after the fact)!

Imagine what an incredibly different world we would be living in if this became a reality? Stockbrokerages would start hiring small cap analysts, investors would get research on stocks they have never heard of and listed smaller companies would suddenly get exposure.

If the JSE does nothing mentioned here else, I really hope that they do this. South Africa and our small cap market be immeasurably healthier with this initiative in place.

Other Solutions

Here are a range of other possible solutions:

JSE should spend (more) on retail investor education,
JSE should host (more) investor days hosting a range of CEOs for the public to dial in/meet,
JSE should host analyst days where sell-side analysts can pitch their best ideas to the public, &
The JSE should build, host & update a research portal that includes searchable, meta-tagged & date-stamped research subsidized by the Fund (noted above), all recordings of the retail investor educational topics, CEO investor presentations & analyst best-idea presentations. This website should be available to the public.

Conclusion:

In summary, the changes, rationale, costs and benefits I propose are below:

Change	Rationale	Cost	Benefit
Joburg Depositary Receipts (JDR)	Stem the flow of capital off the JSE into offshore markets by making offshore markets accessible directly on the JSE.	Negligible as the listers of the JDR’s (probably the banks) would carry the costs as they would also be the ones earning the market-making spreads and management fees on the JDRs.	Besides added trading volumes, brokerage and, perhaps, even listing fees, this initiative should keep capital within the JSE’s ecosystem that would generate annuity income as it trades into other stocks over time.
Free Real-time Data	Lower the barrier to entry for small retail investors. Lower the costs of investing on the JSE.	Potentially up to a quarter of the JSE’s annual profits. Materially less than this if only retail accounts and selective real-time data is made free.	Lower barrier to entry and lower costs should attract more participants. More participants bring more capital, more trading and, therefore, more trading revenues to the JSE. More trading on the JSE will therefore attract more listings, which will garner more trade and so on.
Lower the Costs of Being Listed	On the Main Board of the JSE, listing requirements are regressive costs penalizing companies the smaller they are.	Negligible costs to the JSE as most of these revenues are earned by lawyers, advisors and non-executives external to the JSE.	This should make listing on the JSE more attractive for non-large cap companies and, therefore, as an elastic service, it should see more new listings coming to the JSE. More new listings mean more listing fees, more annual fees and more trading fees earned by the JSE. If the JSE creates central shared services on a commercial basis, this could both lower costs and generate income for the exchange.
Pooled Small Cap Sell-side Research Fund	The economics of monetizing research counts against covering the smaller listed companies. By creating a subsidy (and a public research portal with this subsidized research), the JSE can neutralize this negative effect in its ecosystem.	R10m per annum or less than c.1.5% of annual profits.	This should boost the exposure of smaller companies, lift the trade and liquidity in these companies’ shares, & stimulate investor appetite for them. All this should see more small cap listings and boost trade in smaller companies, which all generate higher trading, new listing and annual listing fees for the JSE. For example, when a growing smaller company is contemplating listing here or on the LSE, TSX or ASX, this would become a differentiating factor in their decision. An added side-benefit of this initiative would be a slew of new analysts being hired and driving coverage of JSE-listed stocks.
Other Solutions	From hosting virtual CEOs and analyst events to driving further investor education and hosting a free online repository of this information (and the above noted subsidized research), the JSE would be stimulating and support existing and new investor appetite in its market.	Other than the above noted R10m subsidy for research, most of these initiatives use fixed costs (i.e. JSE’s building) and relatively cheap technology for reach (i.e. the Internet) and, therefore, are negligible in cost.	These initiatives should not just add value to existing retail investors but should attract new ones. More participants and more active participants bring more capital, more trading and, therefore, more trading revenues to the JSE. More trading on the JSE will therefore attract more listings, which will garner more trade and so on.
Including Single Stocks into TFSA	Unlock capital in the JSE’s ecosystem.	None, though note that the JSE cannot effect this change and, thus, will need to spend some time engaging with National Treasury on this.	This would add liquidity and capital to the JSE’s equity market. More capital means more trading and, therefore, more trading revenues to the JSE. More trading on the JSE will therefore attract more listings, which will garner more trade and so on.
Tax-deductibility of investments into small/mid cap unit trusts	Push new capital into the JSE’s ecosystem and, specifically, incentivize it to invest in the smaller listed companies.	None, though note that the JSE cannot effect this change and, thus, will need to spend some time engaging with National Treasury on this.	A tax incentive to invest in the smaller listed companies would stimulate capital allocation to this part of the market. This would stimulate liquidity and new listings in this space, which bring more trading fees, new listings fees and annual listing fees to the JSE.

The same thinking that got the JSE stuck in its current negative feedback loop will not get it out of it. Without changing how the JSE approaches and nurtures its ecosystem there is unlikely to be a change in outcome. Finally, without nurturing the smaller, more vulnerable listings, the JSE will forfeit future success stories that may become large, material listings later.

I am available if the JSE wants to engage on these and other ideas to improve our domestic equity market.

Kind regards

Keith McLachlan

Twitter: @keithmclachlan

LinkedIn: Keith McLachlan

The Problem: A Negative Feedback Loop

The Solution: (Cheaply) Kickstart a Positive Feedback Loop

Other Solutions: Long-term (Small) Legislative Changes

Conclusion: