While macroeconomic news has continued to moderate, Invesco’s European equity experts see M&A as one area that provides reason to be cheerful.
“Cheap valuations in combination with strong corporate balance sheets and a market rewarding takeovers justify an optimistic outlook – provided company boards become more confident,” writes John Surplice, fund manager at Invesco Perpetual, in the latest issue of the Invesco publication Risk & Reward.
M&A activity has begun to pick up of late, with globally reported deals from Merger Market up around eight per cent year-on-year in the first half of 2010.
Aside from the fact that M&A – traditionally a strongly procyclical activity – has considerably lagged behind stock market increases so far, the Invesco Perpetual analysis points to several other factors supporting a continuation of this trend.
First, European equities currently appear cheap in both absolute terms and compared to corporate bonds. According to Surplice, this opens up opportunities for attractively priced takeovers. While low valuations also restrict the use of companies’ own shares as an acquisition currency, crisis-induced rationalisation measures have left corporate balance sheets in good health and many companies with enough “firepower” to finance acquisitions.
In addition, high-quality companies are able to tap the bond markets and bank financing again. This privilege over lower-quality companies is seen to underpin the premium that Invesco Perpetual’s investment experts believe high-quality companies’ equity should trade at.
“The return of M&A may help the market to better reflect this competitive advantage in stock market valuations,” Surplice says.
According to the investment expert, one of the most significant factors behind a potential increase in M&A activity is the fact that the market now appears to be rewarding companies for making bids – in contrast to normal market reactions in the past when bidders’ stock prices tended to underperform the market in the weeks following the announcement of a deal.
Data from Thomson Financial Data and Nomura Strategy Research show that companies making bids this year have seen their share prices outperform the market by an average of 21 per cent over the 28 days following an announcement, compared to an underperformance of one per cent during the period 2000-2008.
Target companies have also experienced an unusually enthusiastic market reaction this year. They have outperformed the market by an average of 17.5 per cent over the 28 days following a bid, compared to an average of 11 per cent for the period 2000-2008.
“This positive reaction on the part of both deal participants suggests that investors are welcoming M&A transactions”, Surplice says. Investors appear keen to see companies making more active use of their free cash flows. After all, the negligible current interest on cash makes its redeployment into another company’s growth story and cost savings likely to be a profitable endeavour.”
While the overall backdrop for M&A thus looks positive, the clouded macroeconomic outlook has capped deal activity so far.
“The rebuilding of confidence that is required to bring boardrooms to rubberstamp large spending projects will be a function of stabilising macroeconomic news and global reassurance that a double dip recession is unlikely,” Surplice says. “Everything is in place bar the appetite, but the door is definitely open.”
A few high-profile deals could send a clear signal that valuations are cheap and that the outlook has improved sufficiently for corporates to start redeploying their increasing cash piles.
