The merger boom is good news for bankers – but it’s a red flag for you

AB InBev and SABMiller, the two largest brewers in the world, have agreed a merger deal worth $107bn. If regulators approve it, the resulting company will control 30% of global beer sales.

We’ll be looking at what this means for the brewing industry in next week’s magazine. But today I want to look at what it means for wider markets.

You see, this isn’t the only high profile merger to go ahead this year. Royal Dutch Shell is still in the process of buying BG for $70bn or so, and then there’s the Charter/Time Warner Cable deal in the US, worth $78bn. Dealogic, which keeps track of mergers, estimates that the number of deals worth $10bn or more has nearly doubled this year.

It’s a bonanza for the bankers and lawyers involved in these deals. But unfortunately, history suggests that mergers & acquisitions (M&A) – particularly mega-mergers – rarely produce good value. In fact, more often than not, they’re the sign of a market overheating badly.

Should we be worried?

Merger booms end badly

There have been several periods in US history where a rise in the number of mergers has preceded a crash, including the booms of the late 1960s and 1970s. But the most prominent examples are the 1920s, and the late 1990s.

In the years leading up to the 1929 Wall Street Crash, there was a wave of firms buying one another, fuelled by cheap credit, a wave of optimism and a law change that made it easy for competitors to merge.

In the late 1990s a similar fad took place. This time the talk was of ‘synergy’ and cost savings, though restrictions in some sectors (such as banking) were also relaxed. The result was that firms merged, then merged again, particularly in the telecom and tech industry. Indeed, the number of mergers in 2000 set a record that had not been surpassed – until this year.

At the same time there was a tremendous stockmarket boom. The S&P 500 hit a top at the start of 2000. It then fell by more than 40% over the next two and a half years.

The most notorious deal of that era, the $164bn merger between AOL and Time Warner, was announced on 10 January, 2000, just weeks before the market reached its peak. The deal proved disastrous, with AOL’s value shrivelling during the dotcom bust.

So why are M&A booms such a troubling sign? Firstly, past experience and several studies show that most mergers destroy value more often than they create it, especially for the firm doing the buying.

Why are they such duds? Mainly because there are always huge transaction costs. These include legal and banking fees, not to mention the premium that the firm doing the buying must pay for the shares.

This means that executives must have a very rosy view of a deal’s chances before they undertake it. Unfortunately, executives are as prone to over-optimism and bull-market fever as the rest of us – which is why they tend to be most willing to do deals right before the market turns. They buy at the top, and sell at the bottom, just like your average investor.

So lots of big, expensive deals being done shows there’s too much optimism around – a bearish indicator. It can also be a sign that executives are getting complacent about the need to make money, often because credit is cheap. Alternatively, they prefer the perks and the ego boost that come with leading empires rather than companies. Again, both are signs of an overvalued market.

Why you should reduce your exposure to US shares

Now, it’s hard to make a conclusive judgement as to whether shares in general are overvalued on the basis of a single measure like this. Also, the merger mania of the 1920s and 1990s went on for several years before the bubble finally popped.

However, it is just another piece of supporting evidence that you might want to reduce your exposure to US shares, which are looking particularly expensive at the moment – both in comparison to their historical average, and other important global markets.

One measure increasingly used by experts is the cyclically-adjusted price/earnings ratio (Cape). This measures share prices against the average profits over the last ten years, to strip out the effects of economic cycles (normal ups and downs in profits, in other words). Today, the S&P 500 has a Cape of 26, 50% above its long-term average. It also compares unfavourably with other major markets, such as Germany (16.6) or the UK (11.9).

There are also some clouds on the horizon for US investors. One is the prospect of an interest rate rise. Given the US Federal Reserve’s past form, we can’t be sure that it will hike rates soon, but it’s getting harder for it to say “no”. When it does raise rates, things could get tricky for US investors, particularly if the dollar goes up too.

We’d favour markets where money printing is continuing and bull fever isn’t quite so pronounced – such as Europe, or even Japan.


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