Canadian Investment Review

M&A Activity Points to Trouble for Stocks

Written by Gareth Witten on Tuesday, July 3rd, 2018 at 12:29 pm

anxiety roller coaster stressWhat do recent M&A volume declines say about the stock market?

We know that over the long-run M&A activity has tended to be highly correlated with the stock market. However, over the past few years this relationship seems to have broken down (see figure below).

Research firm BCA recently reported that accelerating M&A activity tends to coincide with the first phase of the Fed’s tightening cycle, when the Fed is tightening but monetary policy is accommodative (Rollover in M&A Activity, March 20, 2018). The firm also reported that corporate M&A volumes usually peaked at the end of the second phase of Fed tightening cycles, when the Fed is tightening and monetary policy is restrictive. What we see in the second graph below is that US M&A volumes have come off since 2015. This is similar to the trend in Global M&A volume.

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A Credit Suisse Report (To Buy or Not to Buy, February 27, 2017) reported that the US M&A dollar amount and as a percentage of market cap was in decline since 2015. BCA’s point was that the current softening of M&A activity, despite the data being lagged, is not a signal for the top of the equity market and that investors should remain overweight equities for now but look to move to neutral at the end of this year and underweight sometime in the first half of 2019.

 

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There are a few additional observations I would like to make:

First, we know that companies that act early in an M&A cycle tend to generate higher returns than those that act later. This is what Warren Buffet calls the “institutional imperative”. If we are towards the latter end of the M&A cycle then this does not reflect positively for most firms on aggregate looking for targets.

Second, we know that M&A creates value in the aggregate but that the seller tends to realise most of the value. This was represented by McKinsey as the deal value added (DVA) measuring the percentage change in the combined market cap of the buyer and seller from two days prior to the deal and two days after the deal announcement.

The figure below shows that the DVA was extremely high (about 12%) following the global financial crisis but that it’s come off significantly since then, down to about 8% currently.

 

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Finally, research also shows that there is a clear correlation between the size of the premium the buyer paid and the announcement return: small premiums result in positive returns and large premiums results in negative returns. The figure below shows that the premiums of deals have gone up since 2014 (from a McKinsey Report).

 

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Taken together, this doesn’t bode well for current M&A deals – and it’s also a negative sign for the stock market in the next 12 months.


Gareth Witten is executive-in-residence at the Global Risk Institute for Financial Services. This article also appeared in InvestorLiterature.com 

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