The Underdog Companies That Are Mounting An Inspired Comeback

The Underdog Companies That Are Mounting An Inspired Comeback
Carl Hazeley

over 2 years ago3 mins

  • Companies that spend big on cash M&A historically underperform the S&P 500, but the reverse has been true since 2016.

  • Low interest rates mean dealmaking is now seen as less risky, and share buybacks are now so commonplace they’re seen as a given.

  • To figure out which companies are going big on cash M&A, check out a company’s historical cash flow statements, its annual reports, and comments from recent earnings calls.

Companies that spend big on cash M&A historically underperform the S&P 500, but the reverse has been true since 2016.

Low interest rates mean dealmaking is now seen as less risky, and share buybacks are now so commonplace they’re seen as a given.

To figure out which companies are going big on cash M&A, check out a company’s historical cash flow statements, its annual reports, and comments from recent earnings calls.

Mentioned in story

Since 1990, companies that have paid for mergers and acquisitions (M&A) with cash have only beaten the US stock market almost 30% of the time. But recently, that script has flipped: since 2016, they’ve outperformed the S&P 500 almost 60% of the time. And considering that trend hasn’t shown any signs of slowing down in 2021, this could be a good opportunity for you to back these one-time underdogs.

Why are cash M&A companies outperforming now?

There are a few things companies could spend their cash piles on instead of M&A, chief among them shareholder returns – i.e. share buybacks and dividend payments – and investment in the business – i.e. capital expenditure (capex) and research and development (R&D).

But since the end of March, US companies that have spent the most on cash M&A have outperformed those that spend more on share buybacks and dividends by 5%, and those that spend more on capex and research and development (R&D) by 7%.

M&A outperformance

There’s no saying for certain what’s driven the recent outperformance, but there are a few things likely contributing to the phenomenon:

1. Interest rates are at rock-bottom levels.

Most M&A destroys value, which is why companies that spend a lot on those deals historically underperform. But low rates subtly change that dynamic: it’s made the cost of borrowing money low, which means they can afford to strike a – potentially value-destroying – deal without sacrificing other projects or shareholder returns. Investors, then, are more willing to accept M&A in the hopes it’s one of the rare occasions when the risk involved pays off.

2. Share buybacks are commonplace.

Share buybacks were frowned upon once upon a time: they suggested a company couldn’t find attractive investment opportunities within its business, which didn’t bode well for future earnings growth. But investors’ perceptions have shifted more recently, and companies that announced buybacks have been seeing their share prices rise. In fact, buybacks have hit record after record in recent years, as companies return more and more of their cash to shareholders. Now that buybacks are almost seen as a bit of a given, then, they’re not having the same uplifting effect on company share prices. That’s created space for other strategies – like M&A – to push up prices instead.

3. Self-investment goes unrewarded.

Capex – spending on machinery and the like – and R&D have also been relatively undervalued in recent years, which might partly be due to low interest rates. Investors, after all, may prefer to see the company take the opportunity to make bolder, bigger investments like M&A when money’s so cheap, rather than invest in schemes and ideas that might not pan out.

So what’s the opportunity here?

The recent swing in favor of companies that spend their cash on M&A has proved to drive share prices, which means it’s another tool you have at your disposal to assess and pick companies to invest in.

But to actually figure out which ones may fit the bill here, there are two main things to look at. The first is a company’s track record based on its cash flow statements, which can tell you how much a firm’s historically spent on M&A, shareholder returns, and capex. The second is a company’s stated intentions: annual reports include statements on how a firm intends to deploy its cash, and recent earnings call transcripts show how management’s thinking has changed over time – and they’re both accessible via companies’ investor relations websites.

Goldman Sachs has also curated a list of US stocks that have spent the most on cash M&A as a proportion of their market value over the last year. All else equal, these stocks should outperform if the recent trend continues.

The biggest spenders on the list include telecoms giant AT&T, which has spent 11% of its market cap on cash M&A in the last year, Caesars Entertainment (61%), Gilead Sciences (27%), Franklin Resources (29%), PNC Financial Services Group (17%), and Intercontinental Exchange (15%) in the financials industry, Teledyne Technologies (26%), Broadridge Financial Solutions (15%), and NRG Energy (43%).

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG