Last week, while attending a board meeting for our local CFA Society, a term that I haven’t heard for a few years was used in a discussion I was having about the recent flurry of mergers and acquisitions. “Diworseification,” coined by the great mutual fund manager Peter Lynch, was widely adopted by us mere mortals after reading his 1989 book, “One Up on Wall Street.”
His views on the majority of corporate acquisitions were clear when he came up with this term. Instead of reducing risk through diversification, a corporation, especially when it is flush with buying power, will overpay for non-related businesses and ultimately sell those acquired businesses for less than the original cost paid.
Of course Mr. Lynch is right, as the majority of M&A activity has resulted in lower returns for the acquiring company’s shareholders. However, there are many examples of successful mergers and acquisitions that have produced profitable results for the acquiring shareholders. If the acquiring company purchases a business that is in the same or similar business as its own and the price paid is reasonable relative to the expected increase in future earnings, then the probability of a successful merger is high.
As an individual investor, you can take advantage of this knowledge for the benefit of your own long-term accumulation of wealth. I am not suggesting you try and buy the most likely acquisition target, but rather take a signal from today’s merger and acquisition activity to help determine the current value of common stocks in general.
A company can pay for an acquisition in cash, by exchanging shares, by borrowing money, or a combination of the three. Exchanging shares is the likely method when the current level of stock prices is high, or in other words, when the company believes its current share price is fully valued. Borrowing funds pays off when the cost of borrowing is low and funds are easily obtained. When the majority of purchases are made with accumulated cash, you can be somewhat assured that common share prices are very cheap relative to the other two options.
Management is always tempted to spend their shareholder funds, yet pure cash purchases are scrutinised to a much higher level than the use of shares or borrowed funds. When cash purchases rule the M&A market, the general level of stock prices tends to be low. The common sense driver of this statement is simply that when a company can purchase a stream of revenues and profits for less than the cash cost of building the same amount of revenues and profits from its current operations, then it makes sense to buy instead of build.
Take a look at two of last week’s big announcements. Intel offered to buy all of McAfee with cash, while BHP Billiton offered to buy Potash Corporation, again, with cash. Intel was willing to pay a 60% premium for McAfee, and the premium for Potash will ultimately by huge when compared to the closing price prior to the offer. These actions tell us that the general levels of stock prices are low relative to their long-term earnings potential.
The current M&A activity is sending you one more signal that stock prices are cheap. If you are seeking long-term returns, then take a hint and buy.
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