Will M&A activity be the key to stock market growth?

20th January 2014

Corporate activity is likely to be the key to further progress in the stock market in 2014. Stock markets no longer have the cushion of low valuations, and therefore companies have to get active to raise revenues, whether through investment in people, technology or other companies. The latter, merger and acquisition activity, was lacklustre in 2013 contrary to predictions, but there are signs of an early recovery in 2014. Could this be just what stock markets need? Cherry Reynard reports.

2013 is better forgotten by fans of such deals. A recent report by Allen & Overy showed the overall number of deals fell 14% by value and volume over the year. The fourth quarter was particularly bad, with activity dropping 39% by volume and 56% by value as the Lawyer reported. A report by Ernst & Young at the end of last year had similar findings as the Telegraph reported.

But 2014 has started with a bang. As CityAM noted, on Monday 13th January, over $100bn worth of deals were agreed, dominated by Charter’s $61bn bid for Time Warner Cable. But it is not only big headline deals. Companies are divesting themselves of ‘non-core’ assets, creating opportunities for other businesses to swoop in – Samsung is the most recent example as CityAM recently reported, but Vodafone’s exit from Verizon has been arguably the most important.

Many fund managers are now predicting a boom in merger and acquisition activity. Martin Cholwill, manager of the RLAM UK Equity Income fund, says: “When there is enough of an improvement in business confidence, acquisitions may well be seen as a route forward for large companies becalmed by anaemic economic growth to step up their growth rates. The overall strength of corporate balance sheets and cashflows will enable companies to prioritise this, along with dividend payments. This is one of the reasons for my preference for midcaps over megacaps, which are typically bid-proof and far more likely to be doing the taking over of their smaller brethren.”

Mark Nichols, fund manager, F&C European Growth & Income, said: ” Unlike the European sovereigns, corporate Europe has a pretty strong balance sheet at the moment, with cash building up. We think this will trigger an increasing number of M&A deals, which we believe will not only benefit the acquired companies but also the acquiring companies because of low funding costs in historical terms and attractive valuations across the market place – a recipe for attractive returns in the market.”

Of course, we have been here before: witness the excitement surrounding the Invensys/Phoenix Group deals in July of last year. This was supposed to herald a new era of corporate activity, which never materialised as the Telegraph reported. The same could be said of the Vodafone/Verizon deal. Neither brought forth a swathe of deals, but proved isolated pieces of corporate action.

However, companies have greater incentive now. Funding costs are still low, but it is becoming clear that they will not remain low indefinitely. These leaves companies with a ‘window’. Paras

Anand, head of pan-European equities at Fidelity International, says: “In Europe there are still easy monetary conditions, but this may not continue. Companies have limited time to lock in financing at a favourable rate.”

There is another imperative for companies. Shares prices are now relatively high compared to earnings. Companies need to improve their earnings fast to justify the value currently being placed on them by the market. With funding costs low and corporate valuations still reasonable, acquisitions are an easy way to improve earnings.

Richard Peirson, manager of the Axa Framlington Managed Balanced fund, says: “Merger and acquisition activity should be favourable. Balance sheets are strong, funding costs are low and equity is not hugely expensive. This makes acquisitions earnings enhancing. To date, companies haven’t had the confidence, but management teams are now more confident that things are improving.”

Anand believes that companies are increasingly seeing merger and acquisition activity as a means to consolidate their position in markets that are polarising into winners and losers. He adds: “Results from, say, the UK retail sector are much more mixed than might have been expected from the recent commentary around recovery. Merger and acquisition activity will be an increasingly important way to improve a company’s position.”

If M&A activity finally picks up, is it likely to lead to increasing share prices? Peirson thinks so. His forecasts for equity market growth in 2014 are currently a pedestrian 10%, but he believes that could accelerate if corporate activity rebounds.

There are sound reasons to expect a return of merger and acquisition activity in 2014. For the time being, this is likely to be earnings enhancing, as companies tread carefully in an environment that still warrants some caution. Eventually, there may be a return to the giddy days of leveraged buy outs and testosterone-fuelled mega-deals, but it is a long way off. At that point, investors may want to re-evaluate their equity holdings once again.

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