One of the most reliable indicators of a market peak is M&A. When profits near a cyclical peak, sales growth stagnates and the risk of missing earnings targets grows, managements chasing growth at any price, push takeover premiums to extremes.
Ultimately shareholders are the ones who have to pay the price when the wheels come off several years later so, naturally, investors become wary when M&A volumes spike.
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And now is the time for investors to start taking a more cautious stance according to a new report from Moody’s published this week.
The M&A Market Is Flashing a Red Warning Sign
Moody’s research shows that the previous two record highs for yearlong M&A activity involving at least one US-based company as either buyer or target occurred in the third quarter of 2007 and 2000’s first quarter. It comes as no surprise that further number crunching shows that these peaks were set only a few months after cycle peaks for pre-tax profits from current production. The cycle peaks for the yearlong averages of pre-tax profits from current production were set in Q4-2006 and Q4-1997, respectively.
Monday’s research finds that the ratio of M&A to pre-tax operating profits varies greatly over the business cycle. Since 1988, the ratio of M&A to pre-tax operating profit has averaged 90% but has spiked above 100% when the market peaks. For example, the Moody’s report states:
“The ratio of M&A to profits increased from its 73% average of the first four years of 2002-2007’s business cycle upturn to 121% during the recovery’s final two years. Moreover, after averaging 58% of profits during the first seven years of the 1991-2000 economic recovery, M&A soared to 197% of profits during the upturn’s final three years.”
The bad news is this time around the same pattern has developed. Through the first five years of the current recovery through June 2014, M&A averaged 74% of pre-tax profits from current production. But during the two years ending June 2016, the average M&A as a percentage of pre-tax profits surged to 144% and ended the period at 154%. The takeaway from these figures:
“The 154% ratio of M&A to profits for the year-ended June 2016 suggests that the current business upturn is much closer to its demise than to its inception.”
So should investors be cautious? Maybe, although as Moody’s points out, unlike in previous cycles when the value of US stocks has slumped a few months after M&A peaked, this time around there’s been no such decline. Instead, as equity prices have continued to rally, M&A volumes have declined, which Moody’s believes could be an indication that prospective buyers believe assets are overvalued. This in itself may signal a huge change in managers’ attitude to capital allocation. On the other hand, it could be a very clear indication that an equity market bubble has formed:
“Though the moving yearlong sum of M&A is likely to continue to fall from its latest zenith of Q1-2016, the market value of US common stock’s moving 20-day average has rebounded by 16% from its most recent low of February 15, 2016. Nevertheless, M&A has been unable to respond positively to higher share prices owing to how both business sales and profits have yet to convincingly establish rising trends. The fact that Q3-2016’s moving yearlong sum of M&A was down by -12% from its Q1-2016 peak hints of a growing sense among prospective buyers that business assets are grossly overvalued. The longer M&A slides amid a rising trend for share prices, the greater the likelihood that an equity market bubble has formed.”
By Rupert Hargreaves
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