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#Market Strategy — 11.01.2018

The Time Is Ripe For An Acceleration In External Growth

Guillaume DUCHESNE & Roger KELLER

2018 Investment Themes series: Late-cycle theme #2
 

External growth operations tend to multiply in the late stages of an economic cycle, replacing organic growth strategies with those that boost competitiveness. In the US, the implementation of new tax measures (tax cuts and tax breaks for repatriating overseas earnings) should bolster M&A activity and share buybacks. As Europe is lagging in the cycle, its potential for external growth and share buybacks is at least as good as in the US.

A favourable context for M&A and share buybacks

As the economic cycle advances, companies are finding it increasingly challenging to find internal ways of trimming costs and improving profit margins or return on equity. This is especially true of the current growth cycle, which is one of the longest on record, having begun in March 2009. Economic growth is well on track, business leaders’ confidence is high, and the economy is showing all the signs of improving in the short term. Against this backdrop, M&A activity is ramping up, and healthy balance sheets usually spur such momentum.

Mergers and acquisitions help to pursue cost and revenue synergies. This is very relevant in the present context of moderate growth in end demand, which is hampered by ageing populations and different needs of Millennials. Market share gains usually increase companies’ negotiating power when it comes to fixing prices. Another factor that facilitates M&A activity is cheap credit.

The US is well advanced in the economic cycle, and in M&A activity too. Nevertheless, there is attractive potential thanks to tax cuts on the cards in 2018 and tax incentives for repatriating foreign earnings. In turn, these tax measures should encourage further share buybacks.

Because Europe is lagging the economic cycle, it has greater potential for external growth. The same applies to share buybacks.

At the global level, mergers and acquisitions (in both volume and value terms) are still below the peaks of 2000 and 2007 (see chart below). Hence, there are many regions in which investors can participate in this theme.

“Event-Driven” alternative funds

These strategies aim to create value by capitalising on the special situations of a company, principally mergers and acquisitions, share buybacks and break-ups. Other strategies (e.g. distressed debt) are long-term opportunities but they are not directly covered by this theme.

M&A strategies: above all, fund managers seek to benefit from the spread between the market price at time t and the price offered by the buyer. Like most alternative fund managers, they can simultaneously benefit from rising and falling prices. Indeed, we often see the share price of the acquiring company fall initially, whereas the opposite is true for the target (acquired) company.

Special situation strategies: there are several types of “special situations” (known as catalysts) which may have an impact on a company’s long-term valuation. This may be an arbitrage strategy between two companies, one of which might announce a restructuring, a privatisation of a public company, a spin-off from a large group or a share buyback programme. The latter event has a particularly high potential given the likely announcement of tax incentives for repatriating cash to the US.

We believe that we are entering a late stage of the economic cycle during which companies should favour external growth, particularly via mergers and acquisitions. In the US, the adoption of new tax measures should support share buybacks. The strategy of picking stocks of companies which are particularly subject to these developments is offering enticing opportunities. Event-Driven alternative funds offer another way of riding these trends.

MAIN RISKS

If the world economy slows down earlier than expected, and abruptly, this would rapidly dampen the appetite for M&A. The same scenario would arise if deflationary fears resurface.

Moreover, a rapid rise in bond yields would also be bad news.

Alternative strategies, such as “Event-Driven”, are sensitive to risk aversion and confidence among investors as well as liquidity in the financial markets. There is a positive correlation with equity markets. Changes in legislation are also a risk to this theme.

 


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