The recent recession dealt a major blow to the core earnings of companies listed on the main market.

Although things are looking up, (PIOJ reported that the local economy grew by 1.5% in the first half of 2011), the high jobless rate and the effects of the uncertainty created by the debt situation in the United States and Europe are likely to flow through to the bottom-line of local businesses, via low consumer spending and depressed revenues.

In the face of falling revenues and earnings, companies have pursued a variety of strategies to buoy their performances. As an immediate response, firms resorted to cost cutting measures. As the efficiency gains from cost reduction have diminished, several companies have begun pursing inorganic growth strategies such as Mergers and Acquisitions (M&A) to drive earnings.

The implication of increased M&A activity and the prospect that a few firms may cease to be going concerns, is a reduction in the number of main market listings.

In contrast to the situation in the main market, junior market firms which are much smaller with less established revenue streams have seemingly been holding their own based on recent earnings releases. It is therefore not a surprise that investors’ have developed an enlarged appetite for Initial Public Offerings of these smaller companies which have all been heavily oversubscribed. The preference shown by investors for junior market stocks, coupled with the tax incentives these companies receive, have helped to sustain the current buzz in activity.

This begs the question, “Are junior market stocks the future for local equity investment?”

Main market companies under pressure

The recession and the aftermath have not been easy on main market companies. From 2005 to 2007, the earnings of listed companies increased on average by a 23% compound annual rate. However, since the recession which lasted throughout 2008 to 2010, earnings declined on average by 2.7% .

The unfavourable company releases highlight the challenges in the operating environment. Cases in point- Trinidad Cement (TCL) and its Jamaican subsidiary- Carib Cement (CCC) which are among the poor performers. TCL and CCC recorded losses of TT$80.32Mn and $1.56Bn, respectively in 2010 following consecutive annual declines in sales volumes. TCL’s weakened financial position resulted in a technical default on its debt. Save for the renegotiation with its creditors, assets used in CCC’s daily operations were at risk of being liquidated and CCC may have ceased to continue as a going concern.

In the case of Cable & Wireless, investors are increasingly concerned about mounting losses which have eroded the group’s equity base. Of note, CWJA’s revenues came under pressure from increased competition in the Telecoms industry which pre-dates the recession. However, weaker consumer disposable income has placed even greater constraints on the company and has magnified its operating losses which moved from $496Mn in 2008 to $2.50Bn in 2011. Companies that continue to perform poorly could either fail and be de-listed, or could become just a shadow of their former selves on the stock exchange.

Firms have tried to temper the impact of falling revenues through extensive focus on cost reduction and more recently through inorganic growth strategies such as Mergers and Acquisitions. Operating costs on the main market have risen on average by roughly 4.3% over the last two years. This is much slower than the pace of inflation which ranged from 10.2% to 16.8% during 2008-2010 periods. Local companies sought to reduce overheads by shedding non-core and unprofitable businesses as well as through staff retrenchment. Supreme Ventures closed its hotel and restaurant business at Coral Cliff Montego Bay (and recently its gaming lounge at Wyndham Hotel), while NCBJ, The Gleaner, Radio Jamaica all undertook staff cuts as an initial response to the recession. As efficiency gains from cost cuts are exhausted, larger companies have been exploring M&A opportunities in an effort to maintain profitability. PanCaribbean has identified M&A activity as a part of its strategic focus going forward. Pan Jamaican Investment Trust announced its planned merger with its subsidiary First Jamaica Investments, and JMMB’s proposed acquisition of Capital and Credit Financial is now awaiting the green light from the regulators. These activities will effectively erase some main market listings from the stock exchange.

The Junior Market

The prospect of fewer main market listings is in contrast to the current buzz in junior market activity. Since its establishment in 2009, a total of 12 stocks have been listed with the JSE hoping to increase this number to 16 by the end of this year. The junior market represents one of the most attractive funding options for qualifying businesses at this time. Equity financing has been chosen by these SMEs due to the incentives that are in place. Unlike companies on the main board, junior market companies receive a 10 year tax concession (providing they remain listed for a combined 15 years) and enjoy a 50% discount on JSE fees. Business owners are particularly attracted by these incentives and while they remain in place, more SMEs are likely to go public.

Investor sentiment towards junior market listings has been very positive as all offers have been oversubscribed. The strong appreciation in the price of several of these stocks post listing has helped to sustain the momentum in this market which has returned 73.7% for 2011 to date. One reason is that investments in SMEs represent something fairly novel to the local equity investing sphere. Prior to this, investors were restricted to the options in the main market and new listings were rare. These smaller companies have been outperforming their main market counterparts with earnings increasing by an average 78.3% in FY2010, which has meant an improvement in the valuation of these companies since their IPO. Further, Junior market companies are at an earlier stage of their growth cycle as such they are likely to grow at a much faster pace than the mature companies listed on the main market.

With the issues in the main market, the current wave of equity investment activity seems to be moving in the direction of the junior market. There are signs that this trend could persist in the near future as more companies are placed on this board. But does this mean that investing in main market listings is a thing of the past? Perhaps not. However, as the weak economic conditions persist and with the data showing that main market companies are the most affected, investors will continue to have reduced interest in these stocks. Therefore, the main market could remain in the background until the economic prospects improve and the positive sentiment towards junior market is extended to equities on a whole.

Simone Hudson is a research analyst at NCB Capital Markets.