Takeover phobia - sensible or spineless?

It is often said that private sharemarket investors buy and sell at the wrong time, dumping stocks in troughs of gloom and buying at or close to market peaks.

It is often said that private sharemarket investors buy and sell at the wrong time, dumping stocks in troughs of gloom and buying at or close to market peaks.

IT IS often said that private sharemarket investors buy and sell at the wrong time, dumping stocks in troughs of gloom and buying at or close to market peaks.

The same tendency infects the behaviour of company directors: they approve acquisitions in bull markets and reject them in bear markets, as they are doing now.

Merger and acquisition data compiled by the Dealogic group records that in Australia takeovers valued at $US128.6 billion were announced in 2007, as a four-year-long bull market peaked. In 2008 as the global crisis gathered pace, M&A deal value fell back to $US86.5 billion and in 2009 it was even lower at $US69.3 billion.

As the market recovered, takeover activity rebounded, to $US126.8 billion in 2010 and to $US136 billion in 2011. But the return of the European debt crisis in the second half of last year has been a deal killer. So far this year, M&A worth just $US23.3 billion has been announced.

That's a miserable annual run rate of just $US77.5 billion, putting takeover activity in Australia back to where it was at the depths of the global crisis.

The story is similar in investment banking equity capital markets divisions, the modern version of the underwriting businesses that stockbrokers used to run.

ECM divisions organise floats, share issues and placements for companies, and they also either organise or directly provide debt. Takeovers are a crucial source of business for them, and as takeover activity has dried up, so has ECM activity. It was worth $US46.1 billion in Australia in 2007 and totals just $US4.3 billion so far this year, for an annual run rate of $US14.1 billion.

The slide in takeover activity signals either another missed chance to buy assets cheaply, or a prescient judgment by boards that the global crisis has changed takeover sums long-term.

On traditional measures, shares are cheap. Ahead of the crisis, fair value for share prices here was considered to be about 15 times expected earnings for the year ahead. The Standard and Poor's/ASX 200 index is trading now at 12.7 times expected earnings.

Another way of looking at that is to say that investors and companies were happy to buy earnings that represented a yield of 6.7 per cent of the price they paid for the ASX 200 index before the boom, and are buying earnings that create a yield of 7.8 per cent now.

The earnings yield on Australian shares fell below 2 per cent at the depths of the financial crisis as corporate profits were crushed. It is now back to levels seen before the crisis and fixed interest yields have meanwhile fallen.

Investors could get a yield of 6.2 per cent on 10-year Australian government bonds in mid 2007, but the yield moved below 4 per cent late last year and is still there, at about 3.8 per cent - 4 percentage points below the ASX 200 yield.

Bank deposit rates have fallen less heavily, from 5.9 per cent for one-year deposits before the crisis, for example, to 5.1 per cent. Even then, however, the sharemarket's yield premium has expanded, from 0.8 percentage points to 2.7 percentage points.

Overseas markets are the same. The US sharemarket is on a yield that beats 10-year US government bonds by 5 percentage points. The yield premium on shares has expanded for a reason, however. It is compensating share investors for risk that is perceived to be higher in the wake of the global crisis. They want bigger returns because they are less confident that share prices and corporate values will recover - and boards feel the same way.

The historical evidence is that successful takeovers occur in markets like this one. This week I asked M&A advisers to tell me which takeovers in Australia have been most successful. The list was long, but a few takeovers scored multiple mentions, and they were all done when markets were weak.

They include the $2.7 billion acquisition of Howard Smith by Wesfarmers in 2001. It created a hardware business that last year earned $802 million, valuing it at about $7 billion. BHP Billiton's takeover of WMC in 2005 for $US7.3 billion brought with it the Olympic Dam copper mine in South Australia, and even after falling 21 per cent from its 2011 highs the copper price is 168 per cent higher than it was when the deal was done, with an open-pit expansion that will triple copper production to come.

Xstrata's bottom-of-the-market $3.2 billion acquisition of MIM in 2003 occurred when coking coal prices were 20 per cent of their current level. Blood plasma group CSL spent $2 billion acquiring two other plasma manufacturers, ZLB of Switzerland in 2000 and Aventis Behring in 2004, created globally significant market power and watched its shares rise sevenfold.

Amcor's acquisition of Alcan's packaging operations during the global crisis is a more recent deal that looks set to fuel double-digit profit growth.

The open question for boards that are contemplating takeovers now is whether the markets can rally as they have in the past.

They might slump if the crisis escalates. Or they might rise and fall within a fairly narrow range as the sovereign debt overhang that the crisis exposed is gradually worn down.

Economic growth everywhere would be lethargic if that happened. Profit growth would be hard to find, the markets would be volatile as mini-crises were dealt with, and share prices would be held down as investors continued to demand outsized yields.

We know, in other words, that companies are reluctant to make takeovers, but don't know yet whether they are once again missing an exceptional buying opportunity, or wisely keeping their powder dry.

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