Deal Activity is On Fire

Posted in: Economics, General, Stock Market, Thought of the Week

Since 2008, companies have been operating at some of the highest levels of efficiency in modern history. They have repaired their balance sheets and are now hoarding cash at record levels to protect themselves from the next downturn in our economy. The reason for holding so much cash is because CEOs have become overly cautious when it comes to spending money. A high cash balance certainly reduces the risk that a company will fall into financial difficulties. However, due to the Fed’s zero interest rate policy, cash earns next to no interest. Companies that must answer to shareholders will typically return some of their excess cash in the form of dividends and share buybacks. Yet, if the CEO sees an opportunity for growth, they will spend this excess cash in two primary ways:

  • Capital Expenditures (Capex): A company will buy new machines, supplies, equipment, and talented labor to build new products and services to sell for a profit.
  • Mergers & Acquisitions (M&A): Instead of building new products/services from scratch, companies will often buy competitors or those that complement their business.

The critical decision to “buy vs. build” is something every CEO will face in their industry. CEOs are compensated based on short-term results. Therefore, they are often incentivized to raise their stock price quickly, and M&A can be a highly effective way to boost earnings and sales in a relatively short time frame. There are a few reasons a M&A may appear to be right move for a company:

  • Time to Market: Management teams typically do not have a long amount of time to prove to shareholders that they are providing value. It sometimes makes more sense to simply buy a competitor in order to realize that potential growth much sooner.
  • Operational Risk: For instance, a drug company trying to decide if they want to start from scratch or buy a proven drug instead. It may take several years to bring the drug to the market and the risk of failure is very high in this market.
  • Synergies: Imagine if two pharmaceutical companies with completely different product lines joined together. The buy could eliminate duplicate sales personnel, land and equipment, and other expenses, yet increase the amount of products to sell on their existing infrastructure.

Since the start of 2014, the largest companies in the world appear far more interested in buying vs. building. The value of deals announced this year has already topped $1 trillion, which is 35% higher than the same period in 2013. In addition, the average deal size has been higher in 2014 compared to 2013 and years prior. Management teams are rewarded faster when using M&A to boost competitive positioning instead of waiting years for capital expenditures to yield rewards.

Our Investment Committee believes this spending is a sign that confidence has returned to these companies. This competitive spirit is back and our Investment Committee expects to this M&A surge to continue to fuel equities high over the long run.

Read this week’s Thought of the Week to learn more about the large deal activity we have seen in 2014.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.