There seems to be a new calculus at work in the recent rash
of takeovers, as investors set aside their usual wariness of
deals for the promise of growth these combinations may bring.
We think its a good reason to stick with stocks.
Announced global deals this year have already hit $1
trillion as of the end of March, one of the highest quarterly
levels since 1998 and almost double the level announced for the
same period a year ago. The trend is reaching across industries
and regional markets with recent announcements including
U.S. pharmaceutical company Pfizers $106 billion (and
climbing) bid for U.K.-Swedish drugmaker AstraZeneca, the cable
giant Comcasts proposed $45.2 billion acquisition of Time
Warner Cable and the pending $35 billion
merger between global advertising giants Omnicom and
recent wave of M&A mania is no shock. Its been
expected for some time. The markets response, however,
has been a surprise. More often than not, the stocks of both
the acquirer and acquired rally on the news of a combination,
friendly or otherwise. But this reaction contrasts with the
historical pattern. From the early 1990s until the past couple
of years, stock market returns for the top quintile of the most
acquisitive U.S. companies have trailed the market by about 9
percentage points annualized. History is rife with acquisitions
gone wrong. For example, the management teams involved overpay
or overestimate the potential value of any synergies coming out
of the deal.
Over the past couple of years, however, returns for the most
acquisitive quintile of companies have outperformed the market
by almost 15 percentage points annualized. Why the big
reversal? Are deal-making managements suddenly geniuses and
careful stewards of capital? Or is something else going on?
By our reading, much of this atypical behavior is a reaction
to the atypically favorable conditions for accretive deals. For
one thing, the bar for evaluating acquisitions has never been
lower. The balance sheets of both acquirers and their targets
are flush with cash, whereas the opportunity cost of capital
as measured by the return that companies get on cash
is next to nothing. Likewise, the aftertax cost of debt
is very low, owing to historically low interest rates and tight
corporate credit spreads.
Moreover, the prospective targets of this cheap capital are
of unusually high quality. The present yield on Baa-rated U.S.
corporate bonds is about 5 percent whereas return on
equity for large-cap U.S. stocks is nearly 17 percent. That
translates to a spread of more than 11 percentage points,
nearly double the average spread of the past six decades (see
chart 1). Thats a powerful tailwind for acquirers.
For cash-rich U.S. multinationals, tax savings can be
another major enticement. Instead of repatriating its hoard of
cash overseas subjecting it to higher U.S. taxes
Pfizer is proposing to use that cash to finance its takeover of
AstraZeneca and reincorporate the new, combined company in the
U.K., where the lower corporate tax rate and other potential
breaks could save Pfizer $1 billion or more annually. Since
2008 about two dozen U.S. companies have used this strategy to
shift to a legal residence abroad via acquisition.
The main concern of the stock market is growth. By our
calculations, stocks are pricing in far less earnings growth
than the 6 percent long-term average, whereas the share of
market valuation accounted for by future growth remains well
below average (see chart 2).
In our view, these factors are precisely why M&A activity
is being so rewarded today. It reduces the uncertainty as to
how surplus capital will get put to work and, with the cost of
capital so low, raises the odds that acquisitions can boost
future earnings growth.
It all works because the spread between the cost of debt and
the return for investing in equity is so wide. Company
managements will find ways to close that gap if the market does
not do it for them. And with the equity risk premium (the extra
compensation earned for investing in stocks relative to bonds)
still well above the long-term average, we think stocks
particularly undervalued stocks remain the best bet for
Joseph G. Paul is chief investment officer of U.S. value
equities at AllianceBernstein
in New York.
See AllianceBernsteins disclaimer.
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