Stocks Lose Buyout Premium as M&A Slows, Yields Rise (Update1)
By Michael Tsang and Daniel Hauck
July 2 (Bloomberg) -- The steepest drop in mergers and acquisitions in 14 months is making U.S. stocks the most expensive compared with bonds in two years.
This year's record pace of takeovers slowed by 37 percent in June, data compiled by Bloomberg show. Delaware Investments, the Hartford and City National Bank, which manage more than $500 billion, say the decline plus the decision by leveraged buyout firm Blackstone Group LP to sell shares to the public are signaling that the five-year bull market is nearing an end.
M&A was the engine behind the Standard & Poor's 500 Index's rise to a record last quarter. The rally pushed the return on shares represented by dividends and stock buybacks 0.18 percentage point below the yield on 10-year Treasuries last month, the worst relative to bonds since March 2005. Only when cash from takeovers is added did stocks yield more than debt.
``Equities are perhaps not as undervalued as people might want you to think,'' said Jordan Irving, who helps manage more than $150 billion at Delaware Investments in Philadelphia. ``It's the extra kicker of M&A that's allowed some of those gains.''
Irving said he hasn't made any new stock purchases since the first quarter because it's been ``very difficult'' to find shares that are cheap.
The S&P 500 posted its best second-quarter performance since 2003 with a 5.8 percent gain to 1503.35 as takeovers increased 77 percent from a year earlier to about $782.6 billion, according to data compiled by Bloomberg as of July 2. The benchmark for American equity slipped 1.8 percent in June as 10-year Treasury yields rose to the highest since 2002, increasing corporate borrowing costs and slowing the record pace of mergers.
Cash Yield
The so-called average cash yield of S&P 500 companies, which includes dividends, share buybacks and proceeds to shareholders from takeovers, fell to 5.32 percent last month from 7.55 percent in March, according to data from S&P, a unit of New York-based McGraw-Hill Cos., and Birinyi Associates Inc., a research firm based in Westport, Connecticut.
When cash from acquisitions is excluded, the yield dropped to 4.92 percent, 0.18 percentage point less than the 5.10 percent monthly average on the benchmark 4.5 percent Treasury note due in May 2017.
The last time stocks were less attractive than bonds on a cash yield basis was March 2005, when the gap was 0.64 point. Including M&A, the advantage stocks had over bonds dropped to 0.21 point in June.
`Major Support'
M&A has ``been a major support for the market,'' said Quincy Krosby, who helps oversee $330 billion as chief investment strategist at the Hartford in Hartford, Connecticut. ``If the market believes that is being negated by more expensive capital, by the risk premium going up, bond yields going up and so on, you're going to look at a substantial pullback in the market.''
Some investors point to the initial public offering by New York-based Blackstone, the leveraged buyout firm founded by Stephen Schwarzman and Peter G. Peterson, as another sign that the best may be over for mergers.
Blackstone, the owner of companies with about 375,000 employees and $83 billion in annual sales, sold shares to the public on June 21 in the largest U.S. IPO in five years. The stock dropped below the $31 offering price in the third day of trading after netting Schwarzman $684 million. The stock fell 42 cents to $29.27 in New York Stock Exchange composite trading June 29.
Blackstone IPO
``If anybody's got the inside track to call the peak, you got to look to that crew,'' said Richard Weiss, the Beverly Hills, California-based chief investment officer of City National Bank, which oversees $55 billion. Weiss attributes half of the market's 6 percent gain in the first half of this year to M&A.
``We've already done in the first half what we thought you'd see for the whole year, and one of the culprits is M&A,'' he said. A further slowdown in deals ``might exacerbate what is already a lackluster outlook.''
By some measures, U.S. stocks are inexpensive. The S&P 500 is valued at about 16 times the average estimated profit for its members, according to data compiled by Bloomberg. That's the cheapest since October 1995 when compared with reported earnings on a weekly basis.
``Ultimately, the corporate sector is doing well,'' said Jack Caffrey, the New York-based equity strategist at JPMorgan Private Bank, which has more than $400 billion in client assets. ``The earnings story is the driver of markets.''
`Plenty of Money'
Companies in the S&P 500 returned an average 17 percent on equity at the end of the first quarter, compared with about 9 percent for the cost of equity capital, according to Strategas Research Partners LLC. The New York-based firm used the yield on the 10-year Treasury note plus 4 percentage points of equity risk premium as a proxy for the cost of equity capital.
``There's plenty of money, and this gap between the cost of money and the expected return is so huge,'' James Swanson, who helps oversee $192 billion as chief investment strategist at Boston-based MFS Investment Management, said from Buenos Aires. ``To me, the arithmetic is there for this to keep going.''
Last month's slowdown in acquisitions is just a blip, Swanson said. The gap between the return on equity and cost of capital shows takeovers are still attractive, he said.
The S&P 500 rose above its March 2000 record on May 30. Deals that month totaled about $347.3 billion, the most in at least a decade, according to Bloomberg data.
June Drop-Off
Takeovers in the U.S. last month fell to $218.1 billion, the biggest drop since a 43 percent slide in April last year, the data show.
The U.S. deal total for June rose after the announcement on June 30 that the Ontario Teachers' Pension Plan will buy Montreal-based BCE Inc., Canada's biggest phone company, for $42.3 billion including assumed debt. Ontario Teachers' partnered with two U.S. private equity firms -- Providence Equity Partners Inc., located in Providence, Rhode Island, and Chicago-based Madison Dearborn Partners LLC -- on the acquisition.
Excluding the BCE deal, acquisitions in June would have fallen 49 percent from the previous month, the biggest drop since February 2006.
``A lot of the early part of the year's gains were tied to M&A,'' said Edgar Peters, who oversees $24 billion as chief investment officer at PanAgora Asset Management in Boston. ``It's always been an issue when you start to see a lot of M&A and IPO- type stuff turn up, because it typically means that you're late in the cycle. That's problematic for the rest of the year.''
Diminishing Returns?
The return that companies earn in profit as a percentage of their stock price is also becoming less attractive as bond yields climb. The estimated earnings yield at companies in the S&P 500 has narrowed to 6.26 percent of share prices, or 1.23 percentage point more than the interest on 10-year Treasuries.
The advantage is less than the 1.88 percentage point at the end of the first quarter, which was the biggest in 20 years.
At the end of last week, 10-year Treasury yields had jumped 54 basis points, or 0.54 percentage point, from their 2007 low of 4.49 percent on March 7. The yield reached 5.327 percent on June 13, according to Cantor Fitzgerald LP, the highest since April 2002.
At the same time, the risk premiums on speculative grade bonds -- those rated below BBB- by S&P and Baa3 by Moody's Investors Service -- increased, indicating investors became more concerned about defaults.
The extra yield, or spread, investors demand to own junk bonds instead of Treasuries has widened to a three-month high of 2.89 percentage points from a record low 2.41 on June 5, Merrill Lynch & Co. index data show.
KKR, Clayton
Rising yields already forced some buyout firms to scrap financing plans for leveraged buyouts.
New York-based private-equity firms Kohlberg Kravis Roberts & Co. and Clayton Dubilier & Rice Inc. canceled last week a sale of $650 million of debt to finance the leverage buyout of U.S. Foodservice, said a person with knowledge of the decision, after bondholders balked at two attempts to sweeten the deal. U.S. Foodservice is a Columbia, Maryland-based unit of Dutch supermarket company Royal Ahold NV.
Thomson Learning, the textbook and educational testing unit of Toronto-based Thomson Corp. being acquired by London-based buyout firm Apax Partners and the Ontario Municipal Employees Retirement System, last month cut its debt sale by 25 percent to $1.6 billion, said KDP Investment Advisors Inc., a Montpelier, Vermont-based high-yield research firm.
Stretching for Deals
Buyouts are costing companies more than ever, while the ability of firms to pay for loans to take over companies has fallen to the lowest on record, according to S&P.
The average purchase price for takeovers in the second quarter rose to 10.8 times the target's earnings before interest, taxes, depreciation and amortization, the highest compared with annual figures since S&P started compiling the data in 1997.
Free cash flow at target companies fell to 1.79 times interest expenses in the same period, the lowest on record, S&P said.
``The quality of some of the deals is what gets me,'' said Barry James, who oversees $2 billion at James Investment Research in Alpha, Ohio. ``It's obvious that they're really stretching to find things to make deals on.''
James, whose James Equity Fund has beaten 96 percent of like funds in the past three years, said he expects the S&P 500 to tumble much as 20 percent by the end of the year. He's selling stocks to increase cash holdings partly because the ability of mergers to drive share gains is ``going to continue to shrink.'' |
