A global shift in monetary policy and a renewed confidence in equity markets mean that animal spirits are back. Subdued growth, falling margins and a low cost of capital mean firms need to consider mergers and acquisitions (M&A) as well as productivity growth. Deal activity has been increasing on the back of low volatility and strength in equity markets. Weak revenue growth and low interest rates could underpin the M&A cycle for some time.
While the headline market valuation (15.5 times forward price to earnings) appears extended relative to history, the divergence in individual stock valuations tells a different story. There is a wide range between the valuation of stocks within industrials, communications, mining service and food and staples. There is also a large divergence in balance sheet strength between stocks within these sectors. M&A activity feeds on asset mispricing.
As the ASX 200 Index approaches its all-time high, the recovery has been far from even. Low growth and falling interest rates have made structural growth and high yielders far more attractive investments while cyclical stocks have had a few false starts and are yet to find genuine support. We think this segment is most prone to opportunistic takeover activity.
In our view, the appetite for M&A becomes roused when similar firms in similar operating environments have varying balance sheet strength.
- Predators see some balance sheets undervalued by the market and they decide to move in because they think they can extract value through synergies.
- On the other hand, private equity predators tend to look more purely on valuation grounds. They often pick the assets apart in order to extract value.
- Some firms may not become targets; instead, their assets may become targets. Alternatively, some firms may want to optimise their asset mix and sell-off non-core assets.
In this environment, the strong survive and weak do not. If all similar firms had similar balance sheets and were valued similarly, there would be very little need for M&A activity.
Global GDP growth is likely to remain below trend and inflation is likely to remain no threat to monetary policy. In this environment, firms are likely to see relatively soft revenue growth. Cost-out and productivity improvements are already providing earnings delta and this is likely to remain a focus. Marginal cost-out from current operations becomes increasingly difficult as the cost-out cycle matures. Firms then naturally look outside the square to grow earnings and animal spirits take over. M&A activity has shown an unusually lacklustre response to the equity market rally that began in early 2016, and this suggests there is probably some pent-up demand.
Despite the weak pace of earnings growth, individual earnings forecasts have been converging. While not a perfect measure, the dispersion between analysts' forecasts can act as a proxy for earnings certainty. 2017 and 2018 saw a rise in forecast dispersion as domestic conditions started to deteriorate (falling house prices, political uncertainty and elevated regulatory risks). As some of the risks now abate, clarity has returned to the corporate earnings outlook. A precondition to work up an appetite for M&A.
- Justin Still Investment Adviser (Authorised Representative: 000279726) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410