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Confidence trick

10/03/2011

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Recent numbers from the office for national statistics show merger and acquisition (M&A) activity involving UK companies reached its lowest level for 16 years in 2010. This is interesting because, when the stockmarket is high, you tend to see a lot of M&A and, when it is low, you tend to see very little – and yet the UK market ended the year within 10% of its all-time high.

It is all a question of confidence. During 2010, the stockmarket went up because companies did a lot better than people had anticipated, cash was generated, costs came down and balance sheets looked in great shape. However M&A did not increase because people were not confident enough about what was around the corner – or indeed about making acquisitions when nobody else was.

Last year industrial company Tomkins was bid for and a price agreed for Brit insurance. We owned both companies because of our investment approach – we look at undervalued companies and each was bought by venture capitalists looking for the same thing.

But when – as now – economic growth is low, management teams get twitchy because there is nothing more boring than running a low or zero-growth business. They start considering deals and so we believe that we will see quite a bit of M&A over the next year or so – especially as confidence in a recovery begins to become self-reinforcing.

Given where balance sheets are today, and the level the stockmarket is now, there are companies with quite a lot of firepower and, with debt financing so cheap too, you could hardly find a sweeter spot for deal-making – all you need is the willingness to do those deals and the snowball will start rolling down the hill.

Of course, you might think people would prefer to do M&A in an environment of low prices but it never works like that. people very rarely buy cheap – in reality, most make acquisitions when they are able to, which is normally when their profits and their cash buffers are high and people are willing to lend them money. That all means confidence is high but, of course, it also means the target share price is likely to be high.

Very few companies do deals at the optimal time – buying low and selling high, which is the entire ethos of our own approach. Indeed, if you look at the correlation between M&A and the stockmarket, companies tend to do it the other way round, which is why so many deals end up destroying value. All things considered, we are very cautious of companies we own doing deals and would rather be a seller than a buyer of businesses involved in M&A.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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