Mergers and acquisitions have been interesting to all investors as this market rallied. Not only was the dollar in free fall, The Ultra Dollar ETF UUP (UUP) has fallen hard, but companies were buying other companies, and investors became very positive as a result. Now, with earnings season looking about as good as it can given the current economic environment, investors have even more to work with.
In fact, nearly everyone is positive, everyone wants to buy the market, and everyone thinks the market is going higher, but just like I waived a flag of caution when the market was near a bottom in August, I am waiving a flag of caution here as the market appears to be near a top. This article concerns mergers and acquisitions specifically.
Before I continue, if you would like to listen to my August opinion on mergers and acquisitions, this 20 minute video that was published in August explains it well (see here).
That presentation was offered before the M&A wave started. My anticipation was based on the premise that corporate America is now finding it difficult to grow organically. Immediate earnings results were very good, and some companies are showing material improvement, but future earnings matter much more to Wall Street then-current earnings.
Year over year earnings results were easy given the horrible figures contributed in calendar 2009. Next year's comparative earnings results will be much different. The leaders of corporate America know that. They know that future results will be much more difficult given the economic landscape in the United States, and they can anticipate the pressure levied on them by their shareholders.
While they thank their lucky stars that China and India are growing the world economy while the United States and other developed nations struggle, they are also looking for ways to grow that might be outside of the traditional organic growth models and the newly implemented strategy by the Federal Reserve to inflate the economy to higher growth and GDP levels (Inflating to prosperity will not work). The alternative for corporate America is to buy other companies with the cash they have on their balance sheets.
Recent M&A activity was not taking place because companies saw a perceived value in the company they were buying but more so because the companies making those purchases recognized that they must show the world going forward and organic growth models will find it very difficult to produce results. The sweet spot, around $1 billion in revenue, as recently brought interest to the Russell 2000.
The Russell 2000 is comprised primarily of small and mid-cap companies that operate within the United States. Some have international exposure, but very few have the global footprint that companies listed in the Dow Jones industrial average have. Speculators believe that these smaller companies operating within the United States are the target of not only potential M&A activity but also private equity.
As a businessman, while evaluating the results of a recent earnings we identify the catalysts quite clearly. It is not the United States, but the global economy including China and India that have spurred earnings and revenue growth rates for the major contributors to our stock market.
Therefore, the focus of corporate America is now turning from domestic investment and focusing on foreign investment, where the growth is. MBA students who cannot tell us why that happens probably will not graduate with honors either. Businesses invest money where they see potential growth. Right now, the growth is overseas.
Immediately, two things come to mind. First of all, trillions of dollars are being held by US companies in accounts overseas. Debates have already raged over whether we should allow that money to come back on shore without taxing it. The United States is the only country that taxes the repatriation of money at such a high level. However, if the dollar is in free fall, and the prospects for growth exist outside of the United States anyway, why would corporate America want to repatriate that money?
An immediate answer would be to reward its shareholders. However, if Goldman Sachs (GS) can issue a 50 year bond at a very low interest rate, and other companies can too, why wouldn't corporate America leave that money offshore, invest in its foreign business which it is growth engine, and borrow money at extremely low rates if they want to reward shareholders.
Because the focus of corporate America is on foreign investment and not domestic investment, the debate about the repatriation of overseas dollars may be a moot one. In addition, the sweet spot for mergers acquisitions, being perceived as the Russell 2000, may be ill perceived as well.
If the focus of corporate America is to grow overseas because that is where the best opportunities exist then corporate America will be much more interested in expanding its global footprint by buying foreign companies rather than buying domestic companies who rely on growth in the United States to prosper.
My conclusion is not that mergers and acquisitions will stop. My conclusion is that the focus of M&A activity will now turn to the global economy and not focus on what others have dubbed the sweet spot. The US economy will continue to struggle for years, the Investment Rate explains exactly why. Although that will also negatively influence the global economy, China and India will continue to offset the weakness in the United States.
Corporate leaders understand if they intend to be prosperous in the years that follow they must focus on markets that are also providing the most growth. Warren Buffet’s Berkshire Hathaway (BRK.A) has already expressed interested in foreign acquisitions; stand up and take notice.
Be cautious on the Russell. We believe that shorting the Russell is an excellent idea so long as the markets remain under longer-term resistance. The Ultra Short Russell 2000 (TWM) is interesting.
Disclosure: Author long TWM