Billion Dollar Babies

Buttonwood

Feb 3rd 2005
From The Economist Global Agenda

A flurry of big acquisitions and better-than-expected corporate profits has heartened a dubious stockmarket recently. Don’t break out the champagne yet

BUTTONWOOD is beginning to feel like a time traveller. When she last shook the dust of London from her feet, Citicorp and Travelers were just merging. It was a dramatic moment, not only because it produced America’s largest financial-services firm but also because it seemed to herald a more general revolution in the sector: cross-selling banking, insurance and securities in a way that regulation, soon to be changed, had largely prevented. She returns, and within weeks Citigroup is selling the last bits of Travelers to MetLife, a life-assurance company. Bancassurance American-style apparently did not flatter banks’ returns.

This is only one of the multi-billion-dollar deals announced in recent days that helped to lift American share prices from their week-on-week doldrums during the first month of the year. On Friday January 28th, Procter & Gamble, a big consumer-products firm, said it was planning to buy Gillette, ditto, for about $57 billion. A string of big buyers, actual and potential, then popped brightly out from the woodwork, mainly in communications, publishing and the media. Most of the firms in the S&P 500 have now announced fourth-quarter earnings and most of these, in turn, were higher than forecast. The granddaddy of them all was ExxonMobil’s massive $8.42 billion after tax.

Thanks to all this, the S&P 500 index climbed out of its week-on-week doldrums and managed to finish the month just 2.5% down on its December close. There are those who set great store by January share-price movements, holding that as goes January, so goes the year. Buttonwood is not a particular fan of “the January effect”: what matters for share prices—or ought to—are the discounted value of a company’s future earnings and the relative attraction of other investments. But given all there is to ponder these days in both stock- and bond markets, the January effect may be as good as anything to go by.

To begin with, what are we to read into this new wave of mergers and acquisitions (M&A)? Some $136.6 billion-worth of deals involving American firms was announced last month, according to Thomson Financial, a research firm—$187.9 billion if foreign deals are included. December was a big month too, with $147.5 billion in American and $307.7 billion in worldwide deals announced. Why this rush of blood to the head? And what does it mean for share prices?

The first question is easier. The slump of 2001-02 is over. The memory of Enron and WorldCom is beginning to fade, and corporate shame with it. America has kept consuming despite the threat of terrorism. Companies have cut costs and put their balance sheets in order, many of them buying back hefty dollops of their own shares. Margins are high: corporate profits in America last year were running at around 10% of GDP, nearly a record. And cash is plentiful: S&P 500 companies alone had almost $600 billion in cash and short-term assets in their coffers last year. That could increase, thanks to a weird one-off tax break for companies with operations abroad.

Dynamic firms are now looking to consolidate their position within their industries and find ways to grow. Refocusing can take different forms, and not everyone is buying. Citigroup, after all, shed its insurance business and is coy about saying what it plans to do with the roughly $2 billion it will be left with in exchange. American Express too, on February 1st, announced that it planned to shed an operation that seemed a poor fit. More firms are likely to divest as well as to acquire.

What the merger wave means for share prices is harder to say. Big acquisitions usually give a fillip to stockmarkets because they indicate confidence in the future and suggest that other companies may be bought at attractive premiums. Investors should keep an eye out for upward drift in the premiums that cash-rich acquirers are willing to pay, as they would be a sign that too much money is chasing too few targets. The deals being done now are at premiums far below the 30-50% seen in the merger wave of the late 1990s. But they are not insignificant. Gillette’s shareholders will get about 18% more than their shares were worth the night before the deal was announced.

Different messages

The conundrum that is exercising Buttonwood’s mind at present is different: are bond markets and stockmarkets living in the same country these days? How can low, flat bond yields be telling us that all is well, with lowish inflation and interest rates here to stay, while share prices that keep failing to break upwards signal that equity buyers are in fact uneasy about the future? Though shares are slightly overvalued compared with historical price/earnings ratios, they remain undervalued compared with bonds.

The broader point, however, may be that investors in both markets have grown complacent during what has been essentially a 20-year bull market in financial assets. Low inflation and low interest rates have been around for a long time, but they will not be with us forever. And here the economic arguments, well rehearsed elsewhere, roll up.

While opinions differ as to degree and timing, America’s economy will grow more slowly this year than last. Evidence from the slower-than-expected fourth-quarter growth of last year was echoed, tentatively, by an Institute of Supply Management survey released on Tuesday. It showed that factory activity slowed in January, and by more than had been predicted. Again, opinions may differ as to whether the Federal Reserve’s key interest rate will hit 3.5% or 5% by year-end, but the fact is that it is heading upward—the Fed, as expected, raised the rate by another quarter of a percentage point, to 2.5%, on Wednesday. The same is probably true of inflation.

None of this is dramatic stuff—nothing like as dramatic as America’s vast fiscal and trade deficits—but it all bears watching. Look for a modest single-digit increase in share prices over the year unless the M&A wave swells sharply. Clint Eastwood’s “Million Dollar Baby” is a great film, but it doesn’t end happily.

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