Thursday, October 23, 2014

Merger Activity and the Stock Market

In spite of this week's dip in the market, the recent trend has been quite positive.  So too is the increase in deal activity (and IB profits!  see Goldman Sachs Profits Jump).  In fact, mergers are strongly correlated with the stock market and it is instructive to consider  some of the possible reasons.

  • Hot markets are often associated with catalysts providing opportunities.  At the beginning of an upturn, mergers provide opportunities for rapid expansion and additional synergies from expanded sales.  As the business cycle matures and product markets become more competitive, mergers provide opportunities for the synergistic reduction in costs.  
  • Deals are easier to finance in market expansions.  Credit becomes more widely available and the acquiring firm's stock is higher priced.  Indeed, the use of stock financing as a form of payment is correlated with market levels.  
  • Related to this, it is sometimes conjectured that acquiring firms can snap up bargains by using their 'inflated' stock.  Not so fast - it is likely that many targets have also experienced run-ups in price.  The resulting 'bargains' may exist, but are not mechanically generated by rising markets.
  • However, there is a theory that firms with overvalued stock can 'lock in' that valuation by buying hard physical assets with that inflated currency.  The ability to implement this tactic requires sellers to be naive about the bidder's inflated price and assumes the hard assets are not also overpriced.  Indeed, bidders using stock tend to underperform those using cash at the announcement of a deal.  More broadly, firms issuing stock tend to drop 1-3% in value upon the announcement.  Issuing stock seems to act as a signal - why issue stock if it isn't at least fairly valued and probably overvalued?
  • Confidence - buyers tend to have increased confidence when their stock price is high.
  • Among the most intriguing reasons given for increased activity in hot markets is the 'pool of exhausted managements' theory.  According to this theory, many owners hang on to their firms in downturns waiting to sell when prices again rise.  The idea makes intuitive sense and corresponds with some known psychological findings:  we often anchor our price expectations on a historically high price.  Nevertheless, it doesn't explain why bidders are more willing to buy at this time - unless one factors in one of the reasons in the above list.
In any event, here is hoping for a renewed market rise and more deal activity.

All the best,


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