Lead Portfolio Manager
Simon Doherty, Lead MPS Portfolio Manager, looks at why the UK’s major equity market has such a lack of technology exposure.
In January next year, the FTSE 100 celebrates its 35th birthday. Like the world around it, the index has not been immune to the winds of change, with only 29 of the original 100 companies represented in the index at the beginning of this year. At its creation, the index served as a clear reflection of the UK economy. Household names like Boots, Marks & Spencer and Tesco featured along industrial giants like Imperial Chemical Industries and Pilkington Brothers. For better or worse, the composition of the index was far more attuned to the UK economy than it is today. Indeed, if you look at the earnings of FTSE 100 companies now, only approximately 25% of revenues actually come from the UK.
If the FTSE 100 has shed much of its domesticity over the past 30 years, how will it change in future? Given the growing size of the Chinese, Indian and other emerging economies, it seems likely that the index will become more exposed to these parts of the global economy. Companies from these emerging markets seeking to internationalise their businesses may be attracted by the FTSE 100’s traditional prestige, the large number of investors willing to trade shares of FTSE 100 companies, and its well-established listing rules.
However, it’s also possible that the same trend might drive certain companies out of the FTSE 100 too. As these economies grow in size, their governments may seek to exercise more control over the products and resources they require, making constituents of the index increasingly attractive takeover targets for state owned companies. So while we may see greater exposure within the FTSE 100 to what are emerging economies today, the nature of that exposure might be very different in the years ahead.
Several high quality FTSE 100 companies have already proven very attractive takeover targets in recent months. Shire, the pharmaceutical company, is in the process of being acquired by the Japanese company Takeda, Sky has recently recommended the bid for the company from Comcast, while Randgold Resources, the gold mining company, has announced the terms of its merger with Canadian counterpart Barrick Gold that will see the loss of its London listing. The immediate risk for the FTSE 100 is that the relative weakness in the pound makes its high quality businesses increasingly tempting targets for foreign investors, particularly US companies flush with cash after recent tax cuts.
Perhaps the biggest question for the future of the FTSE 100 though is whether it can increase its technology exposure. The index is notably lacking in technology companies when compared to other markets, with its dedicated technology exposure currently comprising fairly mature businesses, rather than those at the cutting edge of developments like Alphabet (Google), Nvidia or Microsoft. While technology companies make up around a quarter of the S&P 500, the main index for US equities, this stands at less than 1% for the FTSE 100.
Part of the reason for the FTSE’s low exposure to new technology companies is the funding gap UK entrepreneurs face when trying to expand their businesses. There is plenty of money available from angel and venture capital investors, who tend to commit capital early on in the development of a company. These are known as Series A and B rounds in funding new technology companies. However, there is typically a lack of money thereafter, where technology companies need funding to ‘scale up’. This gap is not apparent in the US, where scale up funding is more established.
If technology companies do want to grow and scale up in the UK, they generally have two options for funding. They can either try listing on the AIM market, designed for small, rapidly growing companies, or go to private equity and venture funds specialising in ‘start-up’ investing. The greater temptation for UK entrepreneurs is to move to the US.
UK entrepreneurs can also apply to venture funds run by various technology companies, who are generally seeking somewhere to invest their money or a way to gain exposure to new trends. But this leads us onto the second reason why there is such an under-representation of technology in the FTSE 100 – merger and acquisition activity. Several leading UK technology companies, both publicly listed and privately owned, have been taken over in recent years, including ARM Holdings, Cambridge Silicon Radio, Imagination Technologies and Autonomy.
UK technology companies are attractive because they tend to be at the cutting edge of their fields. Deep Mind, for example, is now owned by Alphabet, the parent company of Google. The company is a leader in machine learning, with its algorithms able to train its computers with less data than many other companies.
Coupled with this expertise has been the UK government’s laissez faire approach to corporate takeovers over the past 30 years, regardless of the political party in power. So although the country does not lack for technology companies or a technology industry, it seems there are structural reasons for the lack of technology exposure in the upper echelons of the FTSE 100.
While pure technology companies might not become more prevalent within the domestic index, it’s possible that UK businesses may harness trends around technology and the internet more than is the case elsewhere. This is partly because of the willingness of UK consumers to embrace the internet. Online shopping accounts for 17.8% of UK retail sales for example, compared to just 14.8% in the US. This figure is only expected to move higher, with companies like Next already making more than 50% of their sales online. While there are still logistical issues around online shopping, these will almost certainly be worked out in the next few decades. UK companies at the forefront of these trends, like ASOS or Boohoo, could be strong contenders for FTSE 100 inclusion in future should they decide to move their listing.
While there might not be more outright technology companies, the business models of some of the companies entering the FTSE 100 increasingly revolve around information technology. For example, Ocado entered the FTSE 100 earlier this year, with the company’s prospects dependent on its technological expertise in online shopping and delivery. Even companies which seem relatively insulated from technological developments could see their business models transformed. Utility companies, for example, are now beginning to look at how they could use artificial intelligence and machine learning in their businesses.
In the short term, it seems like the FTSE 100 will continue to look much like it does now. The structural barriers to UK technology companies being and remaining listed, including a lack of funding and the government’s relaxed attitude to takeovers, will probably contribute to a continued lack of dedicated technology exposure. While there are active efforts to try to overcome this, they are first likely to bear fruit within the FTSE Small Cap and FTSE 250 indices, the small and mid-cap counterparts to the FTSE 100.
Over the longer term, however, it might be that the FTSE 100 tilts towards a more recognisably British list of traits. A traditional love of the high street, the readiness of consumers to spend money, and a fondness for Friday night takeaways all point to strong growth for internet retailers and associated businesses. The FTSE 100 might not lose its international flavour, but the success of some of its members may lie in some very British characteristics.
Equity markets like the FTSE 100 are always changing, depending on what parts of the economy are doing well. Sharply lower interest rates have pushed up demand for high dividend paying parts of the market, which is one reason behind the significantly higher weighting for the consumer staples sector. Brands like Hellman’s, Smirnoff, or Veet can be relied upon to generate a steady return for investors.
Source: Datastream, September 2018
Other sectors have been left to the mercy of the economic cycle. Energy companies have yet to recover from the fall in the oil price from north of $100 per barrel to less than $30 per barrel in early 2016. Telecoms companies, meanwhile, have had to invest significant money in their businesses, making them unattractive to investors as there is little left over in profits.
Investors are used to receiving a good level of income from the FTSE 100, with energy and materials companies like Shell or BHP Billiton consistently featuring in lists of the top dividend payers globally. The energy and materials sectors are important for the FTSE 100 more generally, accounting for close to a quarter of the index.
Given its reliance on the energy sector for dividends, could the shift away from oil fundamentally change the nature of the index in future? The UK and France have already announced plans to ban the sale of new petrol and diesel vehicles by 2040, and car manufacturers have dramatically expanded their investment in electric vehicles over the past 18 months.
Oil demand is still expected to keep growing well into the 2020s though. Electric car sales are expected to increase to more than six million units worldwide by 2030, but that still represents less than 10% of current annual car sales. While internal combustion engines are likely to become more efficient over the coming decades, oil demand is therefore projected to keep growing into the early 2030s. That should provide plenty of customers for oil companies, and sustain the flow of dividends for investors.
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