With plenty of cash on balance sheets, corporate confidence is back in the black, cheap borrowing abounds and merger and acquisition activity looks set to soar. But how should investors work the trend?
As the global recovery continues against a low interest rate environment, companies are enjoying a state of rude health. Such a positive backdrop has revived confidence. 2014 was the strongest year for deal activity since the financial crisis, with Allen & Overy predicting this to grow further still in 2015.
According to the law firm, last year in Western Europe transaction values were $863bn (£565bn), almost $400bn higher than the previous year and approaching levels last seen before Lehman Brothers collapsed.
Certain sectors led the charge, with pharmaceuticals and telecoms particularly eventful. Representing telecoms, BT’s recent £12bn bid for EE typifies the sector’s move towards a “quad-play” world, where internet, TV, fixed line and mobile phone contracts are entwined.
Alastair Gunn, who runs the £533m Jupiter Distribution and £542m High Income funds, says: “This convergence means the companies want to bundle the services to make the customer more sticky, and with customer acquisition costs very high, if you stop the churn even with inflation, the economics still work in your favour.”
But are M&As always positive for investors? Gunn says the industry mindset has changed from a year ago. In the past, the acquirer’s share price might have fallen post-deal, with the market either recognising all the money had been spent or they had shifted from an ungeared to a more highly geared balance sheet.
Gunn says: “The market would say, ‘it’s M&A, that means they won’t be giving any more money back to shareholders, which worries us’.”
Today, however, he says the market recognises M&A as contributing to more meaningful earnings growth.
“There are a number of industries where that is playing out, leading to more consolidation, putting companies in a stronger position, with strategically more robust businesses for the longer term.”
Ensuring genuine strategic alignment is paramount, with the multiple benefits of both stripping out competition, increasing market share and reaping the rewards from the target’s growth.
But Old Mutual Global Investors’ Ian Heslop heeds caution that M&A can be susceptible to herd mentality.
The manager of the $2.8bn Dublin-domiciled Ucits fund says: “We would argue strongly if you have confidence in what your company is doing, you should be investing in the company itself rather than taking a shortcut and buying someone else’s growth.”
Suggesting chief executives can be guilty of letting egos interfere with their growth ambitions, Heslop says: “It just feels good to buy other companies.” With the caveat that M&A is not always a bad idea, he says: “Sometimes it adds value to the underlying companies, particularly when buying a company in the same industry.
“But without sounding dogmatic, unless it is screamingly obvious why you are doing it we would question it. If a company is purchasing something with its own shares, it flags what the company thinks of its own valuation. Subconsciously you are more likely to use something you think is overvalued for buying something else than if you think it is cheap.”
So, is there a rule of thumb worth following or is each deal always to be taken on its own merit?
Charles Stanley investment analyst Stephen Peters says the obvious area that tends to benefit from M&A is small cap funds.
He says: “There has been a story there for the last couple of years.
Aberforth Smaller Companies always gets takeover targets because it looks at companies in the same way as private equity values them – the enterprise value, which looks at debt and equity together and compares that with the earnings profile.”
Peters says it is easier to assess smaller companies than blue chips. “They are more touchy-feely.”
Another small-cap fund he says is winning through M&A is BlackRock Smaller Companies trust, which has more of a value tilt.
“But there is more than one way to skin a cat. UK companies might be targets for global acquisition by bigger US companies or they themselves might look to pick up much smaller companies here. You would expect the target’s share price to rise – it is usually better for the target than the buyer. It is not just small cap. At the larger end you have seen a raft of M&A, mostly driven by private equity – BAA, Marconi, Lloyd’s, BAE with Airbus and more recently the AstraZeneca/Pfizer deal.”
He recalls Vodafone being “the poster child” for the megamerger, where the share price tanks shortly afterwards, with the company having a reputation for overpaying for its acquisitions.
“Value managers tend to enjoy their companies being taken over – it’s usually good for them,” he says.
So while M&A clearly has its place, investors should try not to be distracted by the headlines and focus on company fundamentals, in spite of such cheap borrowing costs.
Gunn says: “All markets consolidate over time, it is just a case of the strong getting stronger. M&A has its place but I prefer to invest in companies with strong balance sheet optionality. You have to be pragmatic in understanding the underlying nature of the business. Are they looking at growth organically through new product innovation, pursuing M&A where logical or returning money back to shareholders?
“I am supportive of all three, provided they come with the right framework.”