Acquirers fare well as M&A activity gathers steam

Robert D. Ewing, CFA, Co-Head of U.S. Equities, and Shep Perkins, CFA, Co-Head of International Equities, 6/13/2014

In April, the value of announced 2014 mergers and acquisitions worldwide topped $1 trillion — only the third time it has passed that level so early in the year, according to Reuters. Another notable trend, in addition to the increased activity, is the fact that stocks of acquiring companies are outperforming, which has not been the case in the past few years. A likely reason is that equity investors, seeking growth opportunities, believe that these deals will be accretive — that is, add to earnings — and can stimulate growth, for the companies and the economy.

U.S. merger and acquisition spending is on the rise

What’s different today? Looking at M&A activity historically, one might make the case that some buyers were destroying value, which ultimately led to equity declines. With most deals today, however, we are finding the acquisitions in general to be natural strategic extensions for the businesses. The deals can create synergies that make the resulting companies more productive and efficient, and as long as the buyer isn’t overpaying, they are generally good for equity investors.

M&A and stock selection The potential for M&A activity is not a primary factor in our stock selection process. Rarely will we focus on a stock if the only leg of the investment thesis is a potential take-out. Historically, companies that are targets for acquisition have strategic challenges, and if they aren’t acquired, investors will own an underperformer. Because M&A activity today is so robust in the health-care and consumer products areas, it does become a consideration, but it is still only a small component of our selection criteria. Also, in today’s environment, tax advantages are playing an uncomfortably large role in the motivation of many businesses seeking to make acquisitions, and this should be considered when determining the value of an M&A strategy.

Anticipated rise in rates prompts activity Another factor driving M&A activity is the perception that interest rates, which have been low for years, might rise — potentially in the near future. In other words, this means that CEOs and corporate boardrooms are realizing that the most attractive deal-financing windows are open now, but maybe they won’t be open or as attractive for long. In addition, companies are finding it quite tempting to see that in many large deals today, both the target company’s stock price and the acquiring company’s stock price tend to rise, where typically the target company is the only near-term stock-price beneficiary.

In typical M&A activity, moreover, we tend to see larger companies buying smaller companies. But today, we’re seeing big companies buying or attempting to buy other big companies, sometimes with significant tax advantages sweetening the deal.

Of course, some of these deals may not happen, and a common defense of an unwilling target is to go out and buy another company itself — activity that boosts the overall level of M&A. But with respect to the recent large deals, several appear to run upwards of $50 billion each. All of these developments are helping large-cap stocks in general, propelling them to outperform smaller and more growth-oriented stocks.