- Cash-rich corporations are increasingly considering M&A.
- The market is rewarding acquirers generously (for now).
- How can investors position in front of potential M&A without paying an excessive premium that leaves room for disappointment?
Cash balances at U.S. non-financial corporations have exploded in the post-crisis era, despite a rising return of cash to shareholders in the form of dividends and share repurchases. One other option for using that cash has been attracting growing attention: mergers and acquisitions. Strong corporate balance sheets, slow organic revenue growth and high historic margins make the siren song of acquiring one’s competitors an increasingly loud chorus. How do we believe investors should consider the opportunities and risks in M&A?
The recent market verdict on M&A has been very positive (Exhibit 1). In recent quarters, the acquiring companies have been trading up subsequent to deals being announced by unprecedented levels, an average of 10% relative outperformance in the week following the deal’s announcement. History does point to positive first week outperformance on average, but by perhaps 1%-2%. Why might the market be rewarding the stock values of acquirers so generously today? Well, the stars are fairly well aligned at the moment for deals. On average, corporate balance sheets are under-levered and cash-rich by historical standards. Just as share repurchase is being rewarded as a more efficient use of cash than hoarding, so is the purchase of a competitor’s shares, where hope springs eternal for additional synergies as well. Also, the valuation spread between equities and corporate debt remains high (Exhibit 2). Taking on long-term leverage to invest in equities looks like a reasonable bet (at least if you believe that current margins can be sustained). Two other factors support the current optimism for M&A. One, there appears to be some level of growth acceleration (albeit modest and fragile) in the developed markets. Two, market concerns regarding policy uncertainty have abated to post-crisis lows and the perception of decreased government intervention has historically fed M&A confidence and volumes.
So, in the near term, it would appear to be all systems go. However, longer term results paint a less pretty picture (Exhibit 3). Over the longer term, the results for acquirers have generally been poor, with average underperformance over one, two and three year periods. A recent academic paper on the subject by Mehmet Akbulut of California State University* has drawn a lot of attention, particularly in the wake of some recent all stock deals in the technology sector. He goes one step further, by examining the returns of acquirers who use “over-valued” stock as currency. His work shows that these “over-valued” acquirers have historically underperformed by an even larger margin. In fairness, I find significant weakness in his definition of “over-valued” (defined in his work by stocks with significant insider selling prior to the transaction), but even if it is somewhat inconclusive, it and follow-up work by other observers that use a broader definition of “over-valued” are certainly not supportive of the theory that using high multiple stock as currency is value creative.
Given this backdrop, how do we think about the opportunities to position investments in front of potentially accelerating M&A volumes? There are certainly exceptions to the “acquirers underperform” pattern and we are comfortable owning disciplined acquirers adept at buying at reasonable prices, taking out significant costs and finding revenue synergies. That said, we would generally prefer to be on the acquisition end of these transactions. However, we strive to leave the option value of being a potential acquisition target as simply “gravy” on top of a positive stand-alone thesis. Pricing in a significant “takeout option” can often lead to disappointment. What characteristics do we seek that can put us in front of M&A activity?
1. Companies that possess disruptively innovative products:
a. In a world where organic revenue growth remains generally low and internal capex and R&D has been constrained for years, buying the innovation of others is likely to continue, e.g., Big Pharma’s continuing acquisition of biotech platforms.
b. Often acquisitions are done defensively to absorb a potential disruptive threat before it threatens your core business. Nice to own those threats early.
c. Valuation is always the question mark with these names. Assessing the value versus potential market opportunities for rapid growers is admittedly an imprecise science.
2. Businesses with solid brands and competitive “moats” that simply lack beneficial scale:
a. A notable example would be the strong liquor or beer brands that have been acquired by larger players with broader distribution.
3. Bruised, but not broken, franchises where a stumble has led to discounted valuation:
a. A contrarian eye can sometimes find businesses that have not lost their core competitive advantage, yet are being cast aside as if they are in secular decline.
4. Cheap companies where a new buyer could extract significant costs:
a. These seem to be getting rarer as the easy pickings have already been acquired. That said, there is nothing like a good crisis to flush out opportunities.
*Mehmet Akbulut, 2013. “Do Over-Valuation-Driven Stock acquisitions Really benefit Acquirer Shareholders?” Journal of Financial and Quantitative Analysis, Vol 48, No.4