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Equity Perspectives

Why mergers and acquisitions are likely to increase this year and ultimately help smaller cap companies

Despite the economic uncertainty creeping into capital markets, it seems that this nervousness has not carried over to the corporate boardroom. Back in March, we wrote about the factors lining up to support an increase in mergers and acquisitions (M&A) globally and how this typically has benefited smaller-cap stocks. Between historically high corporate cash balances, an easing of credit conditions in the banking system, and extraordinarily low corporate borrowing costs relative to corporate earnings yields, there was compelling reason to seek growth through acquisition. With the September 8 announcement of another $40 billion of deals globally, according to Dealogic, on top of the strong August tally in the United States of $300 billion, 2015 is already the highest level of M&A activity globally since 2007. 

Conventional wisdom often sites this as classic “top of cycle” activity, as corporations look to bolster sagging revenue growth and counteract peak operating margins. However, given how aligned the current factors are that tend to drive deals and the fact that it was primarily a U.S. phenomenon in 2014, one could argue we’re only in the early to middle stages of a multiyear cycle. In our view, that is certainly the case overseas, where confidence in growth is only now returning and lending conditions are just beginning to ease. (See Table 1).

 

Table 1. Potential M&A Drivers That Could Help Smaller International Stocks


Source: UBS

 

Since our initial view in March, international small-cap stocks, as measured by the MSCI Total Return Small Cap EAFE Index with Net Dividends, have outperformed international large-cap stocks, as measured by the MSCI Total Return EAFE Index with Net Dividends by 460 basis points (March 10–September 9, 2015). Despite this outperformance, we are only now beginning to see numerous small- and mid-cap stocks as the targets of takeover activity overseas. (See Chart 1)

 

Chart 1. International Small Caps Have Eclipsed International Large Caps Since Last Spring
MSCI Total Return Net Small Cap EAFE Index with Net Dividends vs. MSCI Total Return Net EAFE, March 10–September 9, 2015

Source: Bloomberg.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results.

 

Our other contention was that you would start to see activity outside the United States pick up. Year to date, every region is already above 2014 levels, except in Continental Europe. With three months to go in the year, it appears likely that every region will see an uptick. Yet, as you can see in Chart 2, the locus of activity continues to be in the United States. It is notable that despite the turmoil in many large emerging markets, we’re seeing a continuing rise in M&A in the developing world. The majority of this is in China, and is between domestic companies, thus not benefitting international investors by and large. 

 

Chart 2. While the U.S. Has Been the Global Leader, M&A Elsewhere Is on the Rise.
How M&A deals have risen since 2013, deal value in $ (announced, pending, completed), by region

Source: Dealogic.  Data as of 8/31/2015.

 

It remains to be seen if the level of global activity will surpass the record set in 2007 of roughly $4.5 trillion. But the conditions are there to see the momentum carry over into 2016, especially in the healthcare, technology and consumer discretionary sectors (see Chart 3), all of which could make the M&A cycle that started in 2014 one of the largest three-year tallies in history. 

“In global consumer staples, the combination of strong balance sheets and free cash flow from multi-nationals coupled with a struggling competitive landscape should bode well for M&A,” said Lord Abbett Research Analyst Janet King. “A lot of U.S. and European companies are starved for top-line growth and have to either buy their way into it, or find a way to deliver bottom-line growth via M&A synergies or internal cost savings plans. As emerging markets continue to weaken and the competitive landscape intensifies, smaller companies may find it time to sell out. The ideal M&A target would be one with a differentiated product and could benefit from the distribution platform from a global player, as well as cost synergies.  Sometimes this partnership is done through outright M&A or a JV.”

Take, for example, a global consumer products company’s recently announced decision to spin off its fragrance business for 50.1% of another major player in the fragrances sector. “This type of merger is a tax efficient way to combine two entities, and like low interest rates, the favorable tax situation might not last forever,” said Lord Abbett Partner and Research Analyst John McMillin.

But that deal also underscores another trend: multinationals’ shift toward improving their strategic focus as opposed to building scale, which is how they justified huge acquisitions a decade ago. Now with shareholders suffering, some of those behemoths are divesting a number of  brands to improve focus. “As bigger companies divest, opportunities for M&A for smaller consumer staples companies increase,” McMillin added.

The bottom line: we stand by our view that small-cap stocks are the best way to play such an environment, and that the increase in activity we’ve seen so far in 2015 has not particularly targeted the smaller-cap market overseas. That is what an international small-cap investor can look forward to in 2016. (See Chart 4.)

 

Chart 3. Sector Opportunities That Underscore the Potential for Future M&A
Factors that might drive deal activity, acquirers and targets by sector, U.S., Europe and Asia

Source: UBS
For illustrative purposes only, does not represent the performance of any Lord Abbett mutual fund or any particular investment.

 

Chart 4. Global M&A Volumes Set to Increase
How M&A deals have risen from first half to second half since 1995 

Source: Dealogic, UBS

 

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