Value has a role to play

Dear Reader,

This article attempts to identify a connection between several recent buzzwords hanging around newspaper pages that have caught my attention: bond bubble, and mergers and acquisition (M&A) frenzy.

The UK government has been punished harshly by the media and, many perceive, by voters, due to the nationalisation of several large UK financial institutions. The US government has seemingly played a better game.

By providing very cheap money to banks who can then buy government bonds without committing any equity, we have a risk free trade that can allow banks to earn their way out of trouble. Indeed, taking such an argument to its logical conclusion, it is no wonder government bond yields are seen to converge to zero; they may will be converging to the cost of money that banks have to pay. Unless that occurs, money can be made, virtually RISK FREE, with this trade under current regulation.

Can this be an important driver for the large tightening in credit spreads we have seen?

I also emphasis at this point a belief we have presented regularly in this blog; that financing cycles shift from debt to equity to debt continuously over time. After the sudden reduction in bank financing from 2008, equity financing started its cyclical up turn again. However, due to the lowering credit spreads on corporate debt, financing is also becoming abundant from bond issues. We may better call this stage in the financing cycle, “capital market financing”. Indeed, recently, a number of very low leverage, high quality companies such as Johnson & Johnson’s and Microsoft have issued debt at 2 to 3% for maturities at, or greater, than 10 years. This is whilst they both sit on very large cash balances. Such a low cost of capital, which we feel is being fuelled by a loose monetary policy, provides an incentive for companies to accumulate cash, and then, an incentive to do something with this cash. Indeed, newspapers are continuously highlighting the historically high cash balances corporates have relative to market capitalisation. What to do?

With capital market financing only available to corporates, as opposed to consumers, it is unlikely to help the latter increase spending. Hence, is not likely to result in economic growth, as consumer spending is often 70% of the GDP of a developed economy.

So what do corporates do with this cash? Buy a company with the incentive to reduce costs: or buy a company that is trading at the market for less than the cost it takes to replicate its assets (as BHP Billiton did by bidding for Potash).

By reducing costs, they provide the opportunity to increase margins, hence profitability, without relying on growth. If a M&A frenzy was to start, it is likely to be driven by cost cutting rather than expansion. This implies pricing is likely to be disciplined, and may not be the catalyst which will start the price/earning multiple for the market to expand (it has been contracting since 2000). Indeed, few players actually have access to this source of financing. As a result, we feel the stronger may become stronger. This may be a catalyst for the revaluation of dominant, high margin and high return on capital companies that have experienced modest growth over the last decade, but their share prices have done nothing during that same period. It is in this category of companies that our portfolio is heavily positioned.

An interesting question would be, which market structures would be most suitable for such activity? In recent months we have seen most M&A activity in healthcare, technology and commodities (at least at a short glance it seems like that, please correct me if you feel I am wrong, I have no data to back the statement).

I feel healthcare is a wonderful candidate, especially pharmaceuticals. Here we have markets that generally are concentrated with a few dominant players who are experiencing declining growth, and a score of small players with break through products. Usually, when growth was wanted, the big company would buy a small one for the potential of increasing future revenue, and save time and costs on researching for a particular new product. If cost cutting was the aim, would we not see larger companies merge? So cost synergies can really be made? The financing cycle we are in may therefore provide interesting investment opportunities for markets with certain characteristics.

We also note that such transactions are management driven, not investor driven. Hence, if you agree with the above mentioned arguments in concept, you will agree that business dynamics will heavily influence market pricing, not necessarily investor sentiment; at least at the start. Management decisions should be, in a cost cutting environment, more determined by earning yield relative to the cost of financing. In such an environment, value investing will have a role to play in generating good investment results. We strongly feel that value matters, and is the “gravity” that affects the performance of markets in the long run.


Yours sincerely,

Alessandro Sajwani