How I learned to stop worrying and love the crash

As the financial storm ripped through the City of London on the morning of Monday, 19 October 1987, Rentokil finance director Christopher Pearce paid it little heed. He was much more concerned about the real hurricane – Michael Fish’s hurricane – that had struck the southeast of England three days previously.

The problem was that Rentokil was trying to complete the acquisition of a tropical plants company, and it was vital to find out whether or not the greenhouses were still intact and if the plants had survived the battering.

“Others were probably watching those terrible dealing screens with red everywhere, but we were actually trying to get on with running the business,” Pearce says. “In a company one’s concerns about these things is necessarily much more diluted unless one happens to be doing a transaction at that time – issuing equity in a rights issue or making an acquisition and using shares – then, of course, one would be very concerned. Otherwise, they are of secondary concern.”

Ironically, barely three weeks earlier, Pearce would have been a lot more interested in “those terrible screens” and might well have been deeply involved in executing a transaction. He had only moved to Rentokil’s mansion house headquarters in deepest Sussex on 30 September; prior to that he was a City corporate financier at County NatWest.

Safely ensconced in East Grinstead, he had little difficulty leaving the frenetic City environment behind. He even claims to have been “not specifically surprised” by the crash.

“The markets had been very, very high – unjustifiably so, in my view – and everything was becoming very frothy and transaction-oriented. It was one of the reasons that I left the City,” he says. Though with a laugh that would shake a greenhouse he admits: “I didn’t expect it to happen exactly then – I didn’t say, ‘It’s time to leave the City now. There’s only so many days before it’s going to crash …'”

But it wasn’t just share prices that were puffed up to breaking point: “I felt that the whole of the City atmosphere was becoming over-hyped and over-emotional. People were making statements about how things were different this time, and corporate structures were different, and the ability to produce profits was different.”

Some argued that the long-term p/e ratio and yield comparisons had broken down and were no longer relevant in an era where the bull market could seemingly go on forever and ever. Pearce questioned the wisdom of such boom era valuations and their effect on City business. “I worried about all that. I didn’t agree with it, and it was all part of the general move towards a more transaction-based City. I felt very uncomfortable with that. I felt uncomfortable with the general state of emotional atmosphere, the hype that was in financial markets at that time.”

With the FTSE-100 index now brushing against the 5,000 level – more than twice what it was before plummeting a decade ago – and with building society windfalls fuelling some kind of house price boomlet, it is tempting to think financial markets are getting out of hand again. Though he worries about the level of the Dow Jones index on Wall Street, Pearce doesn’t believe that today’s markets have yet reached the ramp factor they had 10 years ago. “Back in those days you had to buy your property because properties were going up at 15%, 20%, 25% per annum,” he recalls. “In the City it was getting to the stage where, if your shares hadn’t gone up 5% in a week then there must be something wrong with them.”

For Pearce, one measure of just how overheated the City had become in the middle of 1987 is that, despite the horrendous October crash, share prices still ended the year at a higher level than at the start. The FTSE-100 index was actually up almost 35 points – 2% – on the year.

What happened on Black Monday and Black Tuesday was, in Pearce’s book, not only necessary, but healthy. “It should not be compared with 1929,” he insists. “It was a correction to what was an overblown situation. But it was necessary at some stage because of the whole City atmosphere that had developed.”

Of course, the crash wasn’t viewed in quite the same light everywhere.

In 11 Downing Street, for example, the fall was viewed with grave concern.

Nigel Lawson loosened monetary controls to ensure the markets had the liquidity needed to head-off any threatened bank failures. But coupled with what had already been a lax monetary policy (after the attempt to shadow the deutschemark at DM3 to the pound), along with the Budget announcement shortly thereafter that double mortgage interest relief would be scrapped within a few months, markets had too much liquidity. This fuelled inflation and helped prolong and deepen the 1990s recession.

So did the authorities overreact? Was it a mistake that should have been spotted at the time? “Yes, arguably it should have been,” Pearce says.

Generously, he adds: “But people were genuinely concerned about the stability of the financial system at that stage. So although these days the crash looks like a little blip in the longer term upward trend, at the time it was considered quite seriously.”

The government had another reason for being concerned about the crash.

At the time, it was trying to sell #5.7bn-worth of shares in British Petroleum, the last of the Treasury’s stake in the oil major, while the company itself was trying to raise #1.5bn for its own coffers. It was the biggest privatisation and the biggest equity raiser the City had ever seen. But while the share issue was fixed at a price of 330p, the crash dragged the market price down to 285p and below.

The underwriters screamed force majeur. “The American banks in particular were very vociferous,” Pearce recalls. “They hadn’t realised that underwriting meant underwriting.” Ironically, 10 years on, Pearce is now chairman of The Hundred Group of Finance Directors, and City underwriting practices are one of the most important items on his agenda. The Office of Fair Trading has also looked at the way City investment institutions earn fixed underwriting fees for guaranteeing to buy shares that they, as shareholders, would probably have bought anyway.

Pearce doesn’t believe the risks the market was taking were fully understood at the time, but neither is he certain that the crash will have any long-lasting impact on investors’ attitude to risk and risk management. “It does for those who live through it, doesn’t it?” he says. “That’s the point. These are generational things: when you’ve lived through that process, then you do understand that indeed shares can go down as well as up, and indeed they can go down rather a long way.”

Pearce had seen it before, if others hadn’t. Back in his merchant banking days, Pearce was in Hong Kong in the early 1970s when the Hang Seng index spiked from around 350 to over 1,700, then plummeted to just 150 – and all within the space of two years. “It is mass hysteria. You can see it building up: more and more people got sucked into investing in the stockmarket, more and more people expecting immediate gains. They think that shares only ever go up.”

Of course, they were wrong, but if the lesson of Hong Kong did transfer back to London, it didn’t last into the 1980s. Most extraordinary, perhaps, were some of the horror stories that came out of the crash about private investors who had been dealing in futures and options the wrong way. One City analyst personally lost millions of pounds that he didn’t have when his bullish, income-generating strategy of writing naked FTSE index puts fell apart at the seams. “People were playing around with derivatives and not aware of some of the dangers,” he recalls.

The crash raises questions about how companies are valued. How can a company be worth #500m one day and then #400m just 48 hours later? “It depends what you mean by value,” Pearce says, and he points to the current debate on the valuation of pension funds to illustrate his point. “Is the value of pension fund assets, the actuarial valuation based on future dividend flows, or is it market value? If you use the right assumptions, the two should be the same, but they are not.

“The valuation of shares depends to a large extent on the future. As valuations get higher and higher, more and more of the value is based on the future expectations. Thus as the FTSE gets higher, then future expectations are the deciding factor and they can change very widely and very quickly.

“We tend to know what we mean when we say a stockmarket is overvalued or undervalued, but if you actually say, ‘Is that the wrong value for a particular share at the moment?’ then you are asking a rather more precise question. But by definition that is the market and people are buying and selling shares at those prices – clearly that must be the right value for those shares. But it doesn’t mean that it will be the right value tomorrow or in half-an-hour’s time.”

Pearce recently listened to the arguments being put forward by PDFM, the fund management group that has been bearish on equity markets for most of the last 1,000 point rise in the FTSE index. In the US, they point to the fact that Coca-Cola, for example, was valued on a p/e ratio of just 12 back in 1982, but has more recently been into the 40s.

“The degree of undervaluation and overvaluation that you get in the peaks and troughs is so extreme that it’s not based on rationality,” Pearce argues. “That’s what one has to bear in mind with markets. Markets really can move from one extreme to the other very quickly these days, because of – though it’s a cliche – the speed at which information spreads.

“The volatility of the markets is getting far more extreme because the speed with which people learn about things and the speed with which they can act is so much greater, that these things become cumulative and so the volatility of the markets is a lot greater.”

Ironically, perhaps, this increase in volatility comes as analysts are apparently getting better at their jobs.

Pearce certainly believes that City analysts are more sophisticated today than ten years ago: “I think they are more professional in the way they track companies, the information they look for in their analysis of companies.

They certainly understand us better.” That, Pearce concedes, may be partly because, with a market capitalisation of #6.5bn, Rentokil is about ten times bigger than it was a decade ago, and so it naturally attracts much more investment interest.

He also welcomes the rise in the number of analysts who work on the “buy side”, in the institutional investment houses: “It adds to the expertise and the intellectual input that goes into looking at companies.”

Financial management within companies themselves has also improved since the 1980s and, coupled with the more intelligent approach to investment appraisal by the City, has taken industry away from the simplistic mantra of the so-called “earnings-enhancing” acquisition that so dominated much of the 1980s bull market – acquisitions that did little in terms of quality of earnings or cash-generation.

One of the great 1980s bull market mergers was Burton’s acquisition of Debenhams. Today, Pearce is a non-executive director at Burton Group, which is currently preparing to spin off the department store chain again.

Pearce won’t comment on the wisdom of the original purchase – though he emphasises that Debenhams’ cashflow supported the Burton chains through the early 1990s.

Pearce remains unconvinced, however, about the City and financial management’s newest mantra, “economic value added”, or EVA, a performance measurement and reward system developed and promoted by New York consultancy Stern Stewart. At the heart of the system is a methodology for calculating the cost of capital, which is to be deducted from the return on capital so as to calculate the economic value added.

Pearce has his doubts about the cost of capital calculation, in part because it is based on “average” market returns. Typically, companies seem to have a weighted average cost of capital between 12% and 14%. But he argues: “That is assuming you generate average returns. We as a company have an objective to produce for our shareholders a growth in profits and earnings per share of at least 20% per annum (see panel on page 16).” That figure, then should be regarded as the cost of capital: “If I am getting any less than that then I am not really providing my shareholders with what I am aiming at.”

But he commends EVA for bringing home the notion that using capital has a cost: “That is where it is a good thing,” he says.

Whatever the City’s fad of the year may be, it is certainly true that investor relations takes up much more of Pearce’s time than it did a decade ago – particularly with US investors. “There are a number of large US investors who are really quite demanding in their contact with the company and the information they want from us. They like to be in touch with the management and to know what the management is thinking and doing. I think this is a good thing – it shows they care.”

Rentokil Initial’s rural headquarters could hardly be further from Wall Street, or the City. Pearce has a share price information screen by his desk, and on the day of the interview, the London market and Rentokil shares had a little shudder. Pearce noticed, but didn’t dwell on the mini slide. Worries about the vascillations in the City are a thing of the past for him, both career-wise and geographically. “It was a very pleasant change,” he says of his shift from corporate finance in the City to industry in Sussex. “I’d recommend it to anyone.”

Rentokil Initial’s 20% solution

One thing that hasn’t changed at Rentokil initial over the last ten years – so far – is the company’s commitment to grow its pretax profits and earnings per share by 20% a year, every year. Other companies have had similar guidelines; the difference at Rentokil, Pearce says, is that the company has actually achieved the target without fail. The problem however, is that what started off as an internal objective in the early 1980s gradually spilled out into the stockmarket and has become virtually a mantra – with analysts and City scribes keeping close watch for the day when Rentokil fails to match its record, hoisting itself on its own petard.

“It’s not comfortable,” Pearce says. “It’s a pressure. Perhaps that’s a good thing. I would think the shareholders would like us to be under pressure.”

The objective, he says, tells shareholders what it is that the management is trying to do with the company. It gives a much clearer message than does some “woolly” mission statement, he believes. “They tend to have conflicting objectives like ‘Keep the customer delighted’ and ‘Produce good profits for the shareholders’. Well, those two things are inevitably in conflict. Yes, you obviously have to provide services that your customers want, otherwise you won’t have a successful business. But to tell everybody in a company that your job is to delight the customer without regard to cost – well, that would result in profits disappearing. You have to give them a profit objective as well.”

A few days before this interview, Rentokil Initial announced interim profits of #194m, up by 44%, but with earnings per share up just 20.3%.

The figures reflected the impact of last year’s #2.2bn takeover of BET (bringing the Initial name to the combined group), but the markets started to speculate whether Rentokil would meet its 20% target for the full year.

Undoubtedly, life would be easier without the 20% rule; the City can be cruel to those that stumble even once. ” We accept that we are on the hook,” Pearce says. “I suppose ideally one might want to get rid of it.

But if you abandon the 20% objective, what are you going to put in its place that will provide the same impetus?”