31 August 2016 by Massimo Fuggetta

Why so few?

Borsa Italiana, Made in Italy Fund

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It is known in finance as the equity home bias puzzle: investors’ preference for domestic equities and their consequent portfolio overweight compared to the precepts of standard theory.

Not in Italy. While laden with domestic government bonds, Italian investors have no penchant for domestic equities. They don’t think of equities as domestic vs. foreign: Italian equities are just a slice of their European equity portfolios, or an even thinner slice of their global equity exposure.

This has little to do with adherence to diversification principles. It is the result of 150 years of underdevelopment – well documented in this volume (in Italian) by the head of Consob Research Department, Giovanni Siciliano, as well as in his earlier book.

Italians’ long-standing misgivings about their equity market have had a huge inertial impact on its growth, which is still being felt today despite decisive progress in laws, rules and regulations over the last two decades. The Italian stock market is still very small compared to the size of the Italian economy. There are only about 300 quoted companies – less than half of the quoted companies in France and Germany and less than a quarter of those in the UK.

Why so few? The standard answer points towards company owners’ reluctance to share control and to submit to public scrutiny. But this is wide of the mark. The problem is not lack of supply. There are hundreds of Italian companies that would be happy to seek quotation and gain access to such an important source of finance and recognition. The problem is lack of demand. In France and Germany, and again doubly so in the UK, there are dozens of fund management firms whose main focus and expertise is the domestic equity market. So a company that comes to the market knows it can rely on a natural interest. If its value proposition is sound, there will be domestic demand for its stock.

Not in Italy, where such domestic focus is noticeably lacking. With few exceptions, Italy-centred funds are managed around the index, which is heavily concentrated in financials and utilities. Add ENI, Luxottica and a few other consumers and you have most of the Italian market – about 50 to 60 stocks in all, leaving little space for the other 250 companies, which are therefore absent in most funds, or may have a token presence in the larger ones, confined to a few decimal points.

Take El.En., a Florence-based producer of medical and industrial laser systems. It has a market value of around 300 million euro and it is 48% owned by its founders and managers. This leaves more than 150 million of free float. Who owns those shares? In a country focused on its domestic equities, one would expect to see a good number of Italian funds among the top shareholders. Not so. The largest shareholder is Dutch, the second is American, the third Swiss, the fourth Belgian, and so on. There is only one Italian fund among the top ten, and that’s the exception rather than the rule.

Let’s compare it to Store Electronic Systems, a French company that sells shelf labelling systems. Same industry – Electronic equipment – same size (270m market cap) and same 52% free float. The difference is that, among the first ten external shareholders, eight are French. And that’s the rule rather than the exception. Similar situation in Germany, where the average level of free float is comparable to Italy; and it is more pronounced in the UK, where the free float is more than double and virtually all major shareholders of smaller companies are local fund managers.

So what have the Italy funds missed by ignoring El.En.? Here is the answer:

Source: Factset

And this is not just the case for El.En., but for dozens of other companies, many of which belong to the STAR segment of the Italian Stock Exchange, where companies are required to submit to stricter standards of corporate governance, transparency and communication. Here is what the STAR segment looks like since inception, relative to the main market index:

Source: Factset

Take a good look at the graph: it says that the value of the Italian market has halved since 2002. It is no wonder, therefore, that the number of Italy funds has also more than halved over the period – so much for the equity home bias. At the same time, however, the STAR index has gone up 2.5 times – a stellar performance which, apart from company insiders, has largely benefited foreign rather than domestic investors.

Low trust, hence no home bias, hence low demand, hence fewer funds, hence few quotations. To invert this vicious circle, it is wrong to start from the end, confusing cause and effect. In economics it is demand that creates supply, not the other way around.

Today there is an ample base for trust. The Italian institutional framework regarding investors’ protection is second to none. This of course doesn’t mean that it’s faultless and problem-free. But issues are similar to those encountered in other markets, and incomparable, in frequency and magnitude, to the shambles of the 20th century.

The next step is to encourage investors’ interest in their home market. But this can only be done by highlighting its strengths, not by reiterating the status quo. Small and medium companies are the core of the Italian economy. So they should be the core of investment funds aiming to revive investors’ latent demand for domestic equities. Only a natural demand for their shares can induce a decisive leap in private companies’ motivation to go public, thus reducing and ultimately filling the gap between the Italian stock market and its neighbours.

The Made in Italy Fund is overtly home-biased – in fact, all it owns is Italian companies. It does so in what we think is the most sensible way: disregarding the general index and focusing on stocks with a market value below one billion euro. It is a universe currently comprising about 250 companies, which are about 80% of the quoted names but represent only 9% of total market value.

Many of the stocks included in the fund belong to the STAR segment, but this is not a requirement. Also, by drawing the line above one billion, we leave out about ten of the largest stocks in the STAR index – successful companies such as Brembo (3.3bn market cap), IMA (2.2bn) and Interpump (1.7bn), which represent more than 50% of the value of the index.

Our goal is to select the success stories of tomorrow. As they grow, the Made in Italy Fund will grow with them, to the benefit of its unit holders. Hopefully, other funds will follow us over time, creating more demand for domestic equities and setting the ground for more companies to come to the market, to the ultimate benefit of the entire Italian economy.

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