When markets are flying high, it’s easy to make the case for mergers and takeover bids. But be wary, says John Stepek.
Merger and acquisition (M&A) activity is picking up fast. A total of $1.2trn in deals was done globally in the first quarter of 2018, a record high in value terms (though not in terms of quantity). The pace shows no sign of slowing – witness the proposed merger of supermarket giants Sainsbury and Asda, and now Clydesdale Bank’s bid for Virgin Money.
The rationale for such deals often seems sensible. Companies in the same sector can unite to cut costs (by merging back offices, for example). And in the absence of rapid organic growth, buying a rival looks like a ready-made way to boost sales and profits, or target new audiences, rather than build the capacity yourself. There’s just one problem. Plenty of research shows that the majority of M&A deals fail to add value for shareholders. Depending on which studies and definitions you use, anything from half to more than 80% of deals fail.
So what’s the problem? Merger deals founder on many rocks. Expectations tend to be high – someone has worked hard to make the case for the deal, which encourages optimism – so it’s understandable that they often fall short. Combining two firms is hard at the best of times – even the most diligent due-diligence process can’t hope to uncover all the potential problems. Even firms that appear similar can prove to be nigh-on impossible to integrate due to huge differences in corporate culture and systems. The takeover of supermarket Safeway by rival Morrisons in the early 2000s is a good example.
But this alone doesn’t explain why so many deals turn out to be such disasters. Instead, the key issue is that company managements make exactly the same mistakes as the average investor – they buy other companies when they are trading at high valuations, rather than when they are cheap. There are predictable reasons for this – when companies are cheap, it’s often against a recessionary backdrop when no one wants to lend or spend, whereas, when times are good, plenty of money is available for empire-building. However, it means you should be particularly wary of deals done during periods of market exuberance – such as the one we’re currently in.
The best deals are done when assets are bought cheaply. As Marc Goedhart, Tim Koller and David Wessells at consultancy McKinsey point out, these sorts of deals are more common in cyclical industries, “where assets are often undervalued at the bottom of a cycle”. Bear that in mind for the next market crash – but for now, you should take all the “synergies” promised in M&A deals with a huge pinch of salt.
I wish I knew what a moat was, but I’m too embarrassed to ask
“I think moats are lame,” said Elon Musk, chief executive of Tesla, mixing his metaphors during a fractious call with analysts earlier this month. The response came to a questioner who asked whether Tesla should use its network of superchargers as a way to gain competitive advantage over rival electric-car makers. A moat in this context refers to a firm’s ability to withstand competition, just as moats used to protect castles from attack. The “wider” the moat, the bigger the company’s competitive advantage.
Moats come in various guises, but they all make it difficult for competitors to take away a company’s customers. For example, a company may be the lowest-cost producer of a product, or it may have a patent on a particular technology or manufacturing process. Strong brands are also seen as a form of moat, because customers have a high degree of loyalty to them. The tobacco industry has a number of moats – the addictive nature of its products, plus a regulatory environment that effectively prevents any new competitors from launching, means the sector is well protected against rivals.
One way to spot a company with a wide moat is to look at its financial track record. If you can see stable and growing profits, large profit margins and a high return on capital employed (ROCE), then the company probably has a decent competitive advantage.
Of course, you then have to work out how long this moat can fend off attackers. One cornerstone of US investor Warren Buffett’s investment philosophy is to buy the shares of companies with exceptionally wide moats, yet when told of Musk’s comment at the latest gathering of investors in his Berkshire Hathaway vehicle, Buffett acknowledged that rapidly moving technology has made moats more “susceptible to invasion”. For example, e-cigarettes are eroding some of the tobacco industry’s existing moats.