Fasten your seat belts.
Article from Forbes, 19 April 1999
If BP Amoco Plc. ends up buying Arco, the huge deal will fit right in with the turn-of-the-century merger wave. Despite the resuscitation of antitrust enforcement, and despite - or perhaps because of - extremely high stock prices, the buyouts just roll along. Last year merger and acquisition activity in the U.S. came to $1.6 trillion, which happens to equal 20% of gross domestic product. If you assume the resulting fees generated for investment bankers, lawyers, accountants, printers and restaurants amount to 5% of purchase prices, the business of buying and selling companies accounted for 1% of the economy last year.
M&A is not a steady business. The income does not flow in regularly every month as it does at the crap tables of Las Vegas. Deals last April were five times larger than those in September. Now we have to worry that when the wave crests we will have a measurable fall-off in economic activity. At a minimum, a collapse in M&A could put a crimp in the U.S. Treasury, since shareholders often either get cash or get shares they immediately sell, generating taxable gains.
It's the size rather than the number of deals that seems to be driving the growth of M&A. A 2% increase in the number of deals in 1998 over 1997 produced an 80% increase in value.
This provides an important pointer to the motivation behind much of today's M&A activity: it coincides with the increasing preference shown by the stock market for large companies.
Before the great 1982-99 bull market began, small companies were all the rage on Wall Street. Research at the time showed that small companies tended to outperform larger ones. A theory like this one can become, for a time, self-reinforcing: small company funds were set up and attracted a large inflow. This pushed up share prices, which in turn encouraged further inflows.
After this pendulum had swung too far, the opposite inevitably happened: large companies did the outperforming. So much that, according to U.K. fund managers Phillips & Drew, the largest 50 U.S. stocks (in market capitalization) now sell at an average multiple 67% higher than the market's average multiple. Two years ago they sold at a discount.
This pendulum swing is getting a boost from indexation – a perfectly sensible investment theory based on the logically impeccable point that the average investor cannot outperform the average. If, therefore, a fund manager can get average performance by buying the index, then he can get average performance at less-than-average cost.
The proportion of a company's shares that are freely traded on the stock market is usually called the "free float". Shares whose free float is below average will tend to outperform when indexation is the rage. That's because the index managers must, by the nature of their discipline, buy a target stock with no regard to its price. Active managers who do care about price will hesitate in buying the index stocks in short supply. The result of all this is that the indexers race still further ahead of the active managers, as the index stocks get driven higher in another self-fulfilling outperformance.
Since those companies with smaller-than-average free floats (as a percent of shares outstanding) will achieve superior performance, there's a strong incentive to shrink the free float. One way to do this is to buy in shares. No surprise, share buybacks have gotten to be a fad lately. The value of buybacks for nonfinancial firms last year was $260 billion, up from $110 billion the year before and only $60 billion in 1996.
This presents a problem for the firms putting the index funds together. With so many buybacks under way, they cannot precisely know the number of shares outstanding and will not therefore be able to know the market capitalization of the companies they are buying, the market cap being the source of the weighting in the index. Standard & Poor's says it tries to adjust immediately for changes of more than 5% in the number of shares outstanding, but otherwise it does this on a quarterly basis. The result is that indexes and index funds will tend to over-weight companies that buy back their own stock.
If this were a one-time-only process, the overvaluation should last only until the end of the quarter, when the index would be adjusted. These days, though, companies buy back their own shares on a continuous basis. The strange effect is reinforced by actively managed momentum funds, whose managers will correctly argue that share buybacks are good for share prices.
The pendulum swings.
Over most of this century, companies have needed more equity capital than they have been able to provide from retained profits. They have therefore been net issuers of shares.
No more. Through diminished share issuance, share buybacks and the retirement of equity in cash mergers, the stock of equity capital in the U.S. is falling. Dividend payments are no longer as much in fashion as they used to be. But note that, for 1998, companies bought shares costing three times their retained profits.
Over the past three years the S&P 500 Index has outperformed active managers by almost eight percentage points a year, according to data from Lipper Analytical Services. That's in contrast to Japan, where active managers have been beating the Nikkei index - and where the free float has been rising, as companies have been selling their cross-holdings.
In this context the resounding level of M&A activity, especially among big companies like Amoco and Arco, plays into the hands of index fans. Even actively managed funds will be nervous of being underrepresented in the largest stocks, and of course S&P 500 Index funds own nothing but large stocks.
Management has responded enthusiastically to the market's liking for share buybacks. This indicates an increased attention by management to share price changes over the short term, rather than on earnings growth over the long term. This new attitude is readily explained by the growth in employee stock options. Executives are now much more concerned about short-term stock performance than by the long-term health of corporations. The favorable phrase for this shift is “"an increased attention to shareholder value".
The bond market has already shown its concern at the rising level of corporate debt by increasing the rate of interest it requires on corporate bonds.
Last year the spread between AAAs and Treasurys of the same maturity rose to 0.9 percentage points from 0.6 points three years ago.
Corporations have therefore increasingly turned to banks for finance. This in turn is a factor in the rapid rise in money supply. M3 is now growing at 10% a year, compared with less than 2% five years ago.
The heady run in M&A activity may therefore ultimately be helping set the stage for a big market correction. As the whole structure requires a buildup of corporate debt, it carries with it the seeds of its own destruction, in particular through its dependence on a continued rapid growth in the money supply.
If the money supply does not slow, inflation will pick up - and if that happens the stock market will fall. Rising inflation killed stocks in the mid-1970s and it can do so again. The market, driven in part by M&A mania, seems therefore to be creating the conditions for its own crash.
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