8th May 2014 by The Harried House Hunter
by Kevin Murphy
The market’s increasing appetite for merger and acquisition (M&A) deals – both actual and rumoured – which is now even seeing corporate titans such as AstraZeneca and Vodafone mooted as potential takeover targets, has in recent weeks led a number of The Value Perspective’s clients to raise the issue of ‘survivorship bias’.
This refers to the mistake of focusing on the people or things who survive a particular process while ignoring those who do not, which can lead to false conclusions. To offer an investment-oriented example, the tendency for fund groups to close down poor-performing funds risks leaving investors with the mistaken impression a sector has performed more strongly over time than was in fact the case.
Survivorship bias, however, is far less of an issue for stockmarket indices – and for two reasons. First, in 2013, only 0.6% of all UK companies went into insolvency – and the percentage of quoted companies that did so was lower still. As such, there will be little impact on the overall ‘quality’ of the index from losing these few businesses.
Second, the overall index composition will be impacted to a much higher degree by M&A and Initial Public Offerings (IPO’s). Regardless of the excitement that tends to surround this sort of corporate activity, there is no real evidence to suggest mergers and acquisitions remove any more good companies from an index than they do bad ones, nor that newly floated companies are inherently better or worse than the incumbents. As such, it is very difficult to argue the UK index has got ‘better’ or ‘worse’ over time. It may, of course, have become cheaper or more expensive but that is a discussion for another time.
None of which is to suggest the takeover of AstraZeneca and/or Vodafone (both of which businesses, in the eyes of The Value Perspective, fall squarely into the ‘good’ camp) would have insignificant ramifications for investors – although, for the avoidance of doubt, we are making no comment on any individual deal. Instead, our concerns relate to what would be left in the UK market in their absence.
One issue is that the UK market is already pretty concentrated, with the FTSE All-Share, for example, having significant weightings to sectors such as banks and other financials and oil and gas. If two of the market’s very largest companies were therefore to leave, the index would only become more concentrated still.
Using rounded figures, the departure of both AstraZeneca and Vodafone from the All-Share would see financials rise from 21% to 23% of the market, for example, and oil and gas up from 15% to 16%. Such increases are significant in themselves but there would be particular implications for UK equity income investors because the vast majority of the country’s dividend payouts come from a few big companies.
Take away one or both of AstraZeneca and Vodafone and that concentration – which you may find in markets such as Australia, Greece or Italy, say, but not in any of the UK’s major peers – becomes even greater. All of which means investors would need to start thinking even more carefully before deciding to use the UK market as a benchmark for such considerations as risk, tracking error or position size.