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Value destroyed through mergers and acquisitions may create investment opportunities

21 February 2013 Wilhelm Hertzog, RE:CM

Opinion piece by Wilhelm Hertzog, Portfolio Manager at RE:CM, value based asset manager

It is a well-documented fact that merger and acquisition activity is usually value destructive for the shareholders of the acquiring company. And yet, the fall in share prices that is commonly seen when reality sets in may offer excellent opportunities for long-term investors.

Chart 1 shows the aggregate merger and acquisition activity in the US compared to the cyclically adjusted price-to-earnings ratio (P/E) of the US market since 1989. The pattern is perfectly clear: merger and acquisition activity peaks in periods of higher share prices, and troughs in periods of lower prices.

Chart 1: US Merger and Acquisition Activity Relative to the Cyclically-Adjusted Price-to-Earnings Ratio of the US Market

  (click on picture to enlarge)

Source: Federal Reserve, Thomson Reuters Datastream

An obvious question that flows from the damning evidence against merger and acquisition activity is why the practice has shown no sign of any real structural decline over time. The best explanation we have come across is that of the institutional imperative, as laid out by Warren Buffett. In short (as it relates to merger and acquisition activity):

⋅ As soon as a company operates successfully, corporate projects and organisational exercises appear, soaking up time and funds.
⋅ The behaviour of peer companies, whatever they do, will be mimicked.
⋅ Any business craving of a leader or senior manager, however foolish, will be quickly supported by his troops using all means available.

The principal/agent relationship between shareholders and management no doubt contributes to this issue of value destructive corporate activity: managers are often allocating 'other people's money'. Hence, they are probably less circumspect about the matter than if they were allocating their own money. When managers weigh the merits of an acquisition, the prestige of managing a bigger firm (deserving of a higher salary) will often tip the scales the wrong way.

Given the evidence and our expressed aversion to owning companies engaging in meaningful acquisition activity, it may seem surprising that RE:CM has invested in the shares of Anglo American, a poster child of capital misallocation during the resources boom of five years ago. A quick look at the ten-year price-to-book ratio (P/B) chart for Anglo American should give some suggestion as to why it has shown up on our radar screens.

Chart 2: Anglo American Price-to-Book Since 2002

  (click on picture to enlarge)

Source: Thomson Reuters Datastream

This is where the opportunity lies for investors in companies that have engaged in mergers and acquisitions. When market sentiment swings from excited and cheerful about the prospects of the newly merged group to dour and grim because the mergers have indeed proven to be value destructive (as they generally tend to be), share prices may well be driven to levels that present attractive long term value. Damning newspaper headlines can easily divert attention from long-term economics.

Among current RE:CM holdings, Old Mutual has been a classic example of this dynamic in action. We were sceptical of the offshore acquisition strategy the company engaged in during the late 1990s and early 2000s, but when the folly of the strategy was finally laid bare in the 2008 financial crisis, market sentiment swung so violently against the company that its shares presented a magnificent buying opportunity. Companies like Vodafone (a former RE:CM fund holding) engaged in similarly ill-conceived acquisition sprees in the tech bubble of the late 1990s, which resulted in much anguish for investors, but also opportunity in the aftermath of the fall out. In both cases, investors who were willing to stomach the short-term negativity subsequently reaped handsome longer-term rewards.

We find similar situations at Anglo American, Bank of America and Hewlett Packard (HP). For Anglo American, market focus has shifted away from things like the commodity super-cycle and emerging market growth to the short-term troubles of the platinum market and execution issues in growth projects acquired in the boom years. In the case of HP, the market’s focus has shifted from what used to be a very impressive printing business to a previous management team that appears to have been asleep at the wheel when doing acquisitions. We agree that the future for HP is likely to be less stellar than the past, but the current share price more than reflects this. These are the kinds of shifts in focus that create interesting opportunities for long-term value investors like us.

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