Royal Mail row shows we still don’t understand markets

Cable is facing the music. Kerim Okten/EPA

Business secretary Vince Cable and the boss of the City is facing questions from parliamentary committees this week over the much-maligned sale of a stake in Royal Mail. So will we finally have a definitive answer to whether a national treasure was sold on the cheap?

Armed with the National Audit Office’s report that suggests the privatisation could have raised an additional £750m for the taxpayer, the committees are quizzing those involved – including Cable, bankers from Lazard, UBS and Goldman Sachs, and Martin Wheatley, the chief executive of the FCA regulator.

It is an easy target to aim at for those who say Royal Mail was sold too cheaply. They can simply point to the stratospheric price rise immediately after the shares were sold to the public and institutions. Within days the price hit 615p, an 86% premium to the issue price of 330p. But hindsight is a marvellous thing, and it is easy to be critical after the event.

Markets are fundamentally hard to predict and that means a premium is almost inevitable. To make an share attractive to investors and ensure a successful sale, the issue price will always be a discount to the full value. In this particular case, it also worth remembering that by retaining a minority stake of 30%, the government will benefit from any increase in share price when it disposes of that investment.

Post apocalyspse?

On the other hand, those who say the issue was fairly priced point to the uniqueness and complexity of the business, its ongoing and incomplete turnaround, its Universal Service Obligation, the need for further substantial across-the-board modernisation and productivity improvements, the inexorable decline in letter volumes, the increasing threat of competition from companies such as Deutsche Post (DHL in the UK), TNT, FedEx, UK Mail in the key parcels business and the possibility of strike action.

Investors may have been able to shove these issues to one side in the rush to buy shares, but as we know, investors can be irrational. There has been a new, albeit challenging, three-year pay and productivity/modernisation deal with the unions, but the problems haven’t gone away.

January’s trading statement was relatively upbeat. It showed a continuing reduction in letter volumes and revenues being offset by revenue improvement in the parcels operations although volumes were flat, but there is now more caution amongst investors who appear to have become less bullish about Royal Mail’s future.

The share price has recently fallen to around 520p, still a 58% premium to the issue price, suggesting markets have blown off some, but not all, of the “froth” that Vince Cable thought was in the post-privatisation price. Recent talk of union action in response to Royal Mail’s decision to remove 1,600 management posts has also weighed negatively on the share price and might raise some concerns over the company’s ability to deliver improvements. More scepticism might be round the corner as The Royal Mail’s annual results are due to be published in May and investors will get a better look at where the business stands.

Lessons for Lloyds

Whatever the prospects for the Royal Mail, though, any stock market valuation is a notoriously difficult exercise. It is heavily dependent on the quantity and quality of information available, assumptions about the inherently uncertain future and investors’ attitude to risk.

In this case, the government and its lead advisors were in possession of all the necessary information but their assumptions were conservative. In arriving at their £3.3bn valuation – about £6bn below the most optimistic estimates – they showed an aversion to risk by attaching significant credence to the potential for future problems at Royal Mail.

They were also determined that the sale should be a success and fearful that an optimistic pricing could dissuade potential long-term holders of the stock. In fact, it turns out that the big investment managers actually went into the market to buy up more stock after the IPO was completed, with this compounded by the stock’s later inclusion in the FTSE100 index. The move onto the blue chip index forced the big index tracker funds to load up on shares, and which further sustained the price.

It is beyond doubt that the government erred on the side of caution in setting the Royal Mail as it sought to ensure the privatisation’s success. It also was trying to transfer to the private sector a business that successive governments had wanted to privatise and that had been problematic for decades; the incentive was there to give it better access to the kind of investment funding needed to further modernise and prosper.

Talking in binary terms about over-valuations and under-valuations belies a misunderstanding of how the markets work, but there are lessons to be learned from this saga. We should learn the importance of taking a more balanced view of valuation and considering different more flexible pricing mechanisms. For example, there should be a stronger link between the strength of investor demand and the issue price. Happily, with Lloyds Banking Group being readied for a significant public share issue, the government may soon have an opportunity show us exactly what has been learned.