Let the M&A boom show you where to put your money in this crazy market

07/15/2011 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The stock market may be more terrifying than campfire ghost stories were when you were ten. Doubts about economic growth litter the ground like beer cups after a NASCAR race. But the merger and acquisition market is hot. Companies spent 20% more money buying other companies in the first quarter of 2011 than in the first quarter of 2011. And the dollar volume of deals is up 40% from the first quarter of 2009, the low for this cycle.

The activity in some sectors is positively frantic. For example, in the chemical industry 2011 is shaping up as a record year for M&A. The first half of the year saw $60 billion in announced deals, an increase of 41% from the first half of 2010.

Now it may seem odd that companies are so willing to invest billions and millions when you and I are having such nightmares about putting our thousands and hundreds to work, and that companies are so willing to buy other businesses when the global economy may be slowing, but it’s actually completely logical.

And that logic suggests a strategy that you and I can use to invest in the currently very volatile stock market.

So what is this logic?

Think about what’s scarce right now. And what’s cheap.

When so many of the world’s developed economies are growing at 2% a year or less—if they’re expanding at all—top-line growth is scarcer than hen’s teeth. And with the cost of raw materials and energy climbing, any squeeze on top-line revenue growth can turn into real pain by the time the money flows through to the bottom earnings line.

But when so many of the world’s developed economies have cut interest rates to near 0%, and then dumped additional cash into the global market through policies like the Federal Reserve’s programs of quantitative easing, money is cheap. In May Google (GOOG) raised money at a yield of 3.63% for 10-year corporate bonds. Johnson & Johnson (JNJ) sold 10-year bonds at 3.68%. Take out the current 3.6% inflation rate, as measured by the Consumer Price Index, and you’ve got essentially free money.

And, of course, many companies don’t need to borrow. At the end of the first quarter companies were sitting on $1.9 trillion in cash.

Do you see how this leads to just one logical conclusion? Growth scarce and money cheap? So buy growth.

But isn’t this strategy risky if you’re a CEO?

  • Not if the stock prices of the companies that you’re looking to buy aren’t at nosebleed levels. The 12-month trailing price-to-earnings ratio on the Standard & Poor’s 500 stocks is just 15.2, well within the range that history calls reasonable. The forward P/E ratio—if analyst earnings estimates are right—comes to just 13.7, well within the range that history calls cheap. (And in a lot of sectors private equity companies are looking for exits. The companies they’re looking to sell don’t always come with a low price but the additional available deals help to keep prices down.)



  • Not if you contrast buying growth to the alternative of investing to create it. Buy a company doing $500 million in annual sales and you can be reasonably sure that even if the economy grows slowly most of that growth will still be there next quarter and next year and the year thereafter. Invest in growth in a slow growth economy and you run the risk of having the market that you want to capture recede into the future so that your company is spending millions or billions chasing a will-o-the-wisp. Just ask electric car battery maker A123 Systems (AONE) when it will see that market reach significant volumes.



  • And not if you’re not investing for tomorrow. Individual investors may get spooked out of a position if growth is slower than expected for a quarter or two or three, but if you run a mining or oil company, for example, you’re planning looks at growth trends for the next decade. Sure, Alcoa (AA) will be depressed if demand for aluminum doesn’t growth by 12% in 2011. But the really important growth is the 6.5% annual growth in demand that the company projected for the next decade. And this kind of long view isn’t limited to natural resource companies. Nestlé’s (NSRGY) deal to buy Hsu Fu Chi International, a Chinese snack and candy maker, for $1.7 billion in cash, has the same long-time horizon. Hsu Fu Chi’s revenue in the company’s last fiscal year grew three times faster than Nestlé’s own worldwide sales. I don’t know what’s more exciting for Nestle, the chance to grew Hsu Fu Chi’s sales more rapidly using Nestlé’s product development and marketing expertise or the opportunity to expand sales of Nestlé’s own brands in China using Hsu Fu Chi’s distribution network. But you can be sure that the company didn’t make the deal with an eye on next quarter’s results.


So what strategic lessons does the current M&A boom have for individual investors?

First, the willingness of CEOs to buy growth at a time of so much short-term uncertainty, both in share prices and in economic conditions, should be heartening to investors who have built their investment strategies on buying long-term growth at a reasonable price. As long as the fundamentals are there, these deals say, the day-to-day gyrations of the stock market are just so much (difficult to ignore) noise. (At its current stage the acquisitions boom hasn’t yet forgotten that valuations in any deal have to make sense and that this isn’t about buying growth at any price. One of the most impressive deals in recent weeks is one that didn’t get done when Brazil’s Vale (VALE) decided not to top a bid from China’s Jinchuan Group for Metorex, a South African company with copper projects in the Democratic Republic of Congo and Zambia because the political risk in those projects ruled out a higher valuation for Metorex’s assets. That came despite rooting from institutional investors and Wall Street analysts who called Vale’s bid 35% undervalued.)

Second, watching to see which companies make what deals gives individual investors a way to separate the companies with solid, well-executed long-term plans from those that flip from strategy to strategy and from opportunity to opportunity. For example, you can follow the intensifying war over the opportunities from the build out of the smart grid for delivering electric power in the acquisitions in that sector. General Electric (GE), ABB (ABB) and Schneider Electric (SBGSY in the United States and SU.FP in Paris) have all made acquisitions in this space in the last year and the pace of deal making seems to be picking up. The acquisition that gives the acquiring company the most leverage in this space is, in my opinion, Schneider Electric’s $2 billion purchase of smart grid software company Telvent (TLVT). Until that deal, Schneider Electric hadn’t been on my radar screen.

Third, better a seller than a buyer be. The recent bid by Peabody Energy (BTU) and ArcelorMittal (MT) for Australia’s MacArthur Coal (MCC.AU in Sydney and MACDY in New York) hasn’t done much of anything for Peabody’s share price—up 1.6% in the three days after the bid was announced. However, it has done a great deal for MacArthur’s share price—up 37% in the three days after the bid. So all you have to do to make a truckload of money is to find acquisition candidates like MacArthur before some company puts in a bid. Sounds like hunting for a needle in a pile of prospectuses, no? Well, I do have some suggestions for winnowing your search.

I’d target sectors such as coal and iron mining where companies are used to working with very long lead times and where supply—hence growth—is very hard to find. (It helps that even if the company you pick doesn’t wind up being acquired, you’ve still bought a stake in very attractive sector.) I haven’t found a coal company yet to replace MacArthur in my portfolio—although the fund does own Whitehaven Coal (WHC.AU in Sydney). You can be sure I’m looking.)

I’d also target sectors such as chemicals and software games where the market is very, very fragmented—lots of players with small market shares. On July 13 Electronic Arts (ERTS) announced that it would buy PopCap Games for as much as $1.3 billion in stock and cash. PopCap is the producer of such “casual” online games as “Plants vs. Zombies” and “Bejeweled.” Electronic Arts—and every other maker of console games--is looking to buy market share in the online game world. Most other U.S. casual game producers are, like PopCap, still private. Take a look at Mumbo Jumbo and Big Fish Games to get an idea of this space. One public company that might make an interesting buy for, say, a Korean game maker looking to expand outside its home market, is Activision Blizzard (ATVI).

And lastly I’d look at sectors where established companies have lots of cash flow but relatively little possibility for organic growth. The commodities sector is flush with these situations. The international oil majors need to acquire growth by buying into unconventional oil share or heavy oil production, for example. Eagle Ford oil share producers such as Petrohawk (HK) and Pioneer National Resources (PXD) suggest the dimensions of potential acquisition candidates.

In the current strange economy—one where corporations are sitting on a ton of cash and where many have substantially strengthened their balance sheets—I think it’s worth adding a merger and acquisition component to your investing portfolio.

It’s not like this stock market is just busting with opportunities to make money, after all.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. As of the end of March the fund owned shares in Google, MacArthur Coal, Nestle, Vale, and Whitehaven Coal. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

 

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