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Merger will out – The current rash of M&A deals may enhance earnings but what about value?

19/02/2014

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Merger and acquisition (M&A) deals have a nasty tendency to work out poorly for the acquiring shareholder – indeed, according to this Financial Times article, academic studies have repeatedly shown around 70% of M&A deals destroy value for the company doing the merging or acquiring. That being the case, something strange appears to have been happening over the last couple of years.

According to Dealogic, after being positive in 1995 – the first year for which data is available – the average share price move of a US acquiring company in the 24 hours after the deal was announced was then negative every year until  2012. Not only was it again positive last year, the 2013 average was – at 4.1% – easily the highest on record.

So why might that be? Perhaps the most obvious explanation stems from the fact companies can, at present, go into the debt markets and borrow at some of the lowest rates in history. Clearly, so long as you can borrow at 3% and then buy a business with an earnings yield of, say, 5% or 6%, you can make a deal earnings-enhancing from day one.

In the past businesses and their investors would have had to settle for waiting perhaps a couple of years – until cost savings, staff rationalisations and other ‘synergies’ had kicked in – for a deal to be earnings-enhancing. Thanks to the current exceptionally low interest rates, that can now happen literally overnight.

Just because a deal is earnings-enhancing, however, it does not automatically follow it is value-enhancing. Sure, the numbers may insist you are making your acquisition on that earnings yield of 5% or 6%, but there will inevitably be issues with the company you are buying. Mistakes will be made, staff could leave and set up elsewhere, systems could struggle to integrate and so on.

In short, M&A is hugely complicated. It involves real businesses employing real people and so all the kinds of reasons why deals destroy value over time can still happen, regardless of the rate at which you borrow. Granted, a lower rate should give you a slightly larger margin of safety but the success or otherwise of a deal does not simply depend on that.

What it will depend on is the price you pay for your acquisition compared with the intrinsic worth of that business. So of course what you really ought to be interested in is not the spread at which you can borrow versus the earnings yield but whether you are able to buy something at a discount to its true fair value.

At the moment, the reality of the situation is the US stock market, where many of these deals are happening, is not particularly cheap. Indeed, according to professional investor and commentator Mebane Faber, the US is the second most expensive market in the world on a cyclically-adjusted price/earnings basis – which is how we like to think about things on The Value Perspective.

All of which would suggest that, irrespective of the rapturous applause with which the market appears to be greeting any new M&A deal these days, investors should be more circumspect. Even though the short-term statistics of the 24-hour spike appear to be working in their favour, there seems little to suggest the longer-term trends of M&A deals will have changed.

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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