This could even lead to investors re- focusing on larger companies, potentially reversing their phase of underperformance against small and mid-caps, he says.
“The success of the listed corporate sector in protecting profitability during the depth of economic contraction over the last few years, has led to balance sheets moving from being conservative to very conservative to, by now, inefficient,” he said.
“Hence, a meaningful recovery in corporate activity could run over several quarters to come, with the deals becoming larger and more strategic.”
“We have been seeing the start of this in the telecoms sector across Europe and in the global pharmaceutical sector this week.”
This general development could have three meaningful impacts for investors, Anand says.
“First, it suggests that valuations, especially of hard to replicate franchises, could appear rich when assessed against short run earnings but reflect not only their longer duration prospects but also the synergies available to any acquiring business.”
“Second, the more strategic nature of such corporate activity may lead to a greater level of investor focus on larger companies which hitherto have experienced a long period of relative underperformance versus small and medium sized companies.”
“Third, it should be relatively supportive for market levels both in the short run but also potentially over the medium term as the process has the scope to improve the equity value creation for the listed sector.”
A pick up in M&A activity has been touted by many analysts and managers as another sign business confidence is improving in larger cap companies after it was all edged US pharmaceutical company Pfizer was attempting a hostile takeover of its UK rival AstraZeneca on April 21, in a deal worth £60bn.
If successful, the deal would be the largest ever takeover of a British company by a foreign company.
The shares jumped 14 per cent on Monday following the news that Pfizer had confirmed its interest in a takeover of despite the bid being rejected by the company.
Performance of stock vs index over 1 week
Source: FE Analytics
AstraZeneca is a very popular stock with fund managers in the IMA universe with 171 funds holding it as a top ten holding.
One of the largest holders of the stock is the £2.6bn Threadneedle UK Equity Income fund run by FE Alpha Manager Leigh Harrison which has 6.4 per cent of its portfolio in the stock, its largest holding.
The fund has returned 45.27 per cent over three years, beating its IMA UK Equity Income sector average which returned 35.33 per cent and its benchmark – the FTSE All Share – which rose 26.28 per cent.
Performance of fund, sector and benchmark over 3yrs
Source: FE Analytics
George Godber, manager of the£64.4m Miton UK Value Opportunities fund says he has been expecting a very significant increase in M&A since the fund was launched 12 months ago, as corporate balance sheets strengthened.
“This [M&A increase] has taken longer to come through than we expected but is now increasing very fast.”
“I would expect this to happen in all sectors apart from financials where you can still expect more divestments of non -core assets.”
“We do not position the fund for M&A, as we invest on fundamentals, but with the fund exposed to some fabulous value situations we do expect if the market does not correctly reappraise the value of those assets larger competitors are likely to step in and buy.”
The fund has outperformed its sector and benchmark since its launch in March 2013. Over this period it has returned 23.55 per cent, compared to an IMA UK All Companies sector average of 13.11 per cent and a rise in the FTSE All Share of 10.5 per cent.
Performance of fund, sector and benchmark since launch
Source: FE Analytics
Deal-making is currently at its highest level since the financial crisis, when it peaked in 2007.
Anand says European companies are now ready for deals in a way they have not been previously since the financial crisis with many likely buyers of European targets are US and Asian companies
“Whilst the national/regional champion deals will always produce more headlines and the political imperative will always mean that governments will need to try and importantly be seen to protect national interests and jobs – as in the case of Alstom - we are likely to see more deals which are US as well as Asian, especially Chinese, businesses buying European businesses in the coming cycle versus history.”
Much of the increase in M&A in 2014 has been centred on the pharmaceutical, particularly in Europe but instigated by US firms.
Anand says this activity demonstrates attempts to purchase companies with specific strengths where additional scale can improve returns.
“Current transactions in the pharmaceutical sector show the logic of the new ‘healthy’ deal type without the complicating political component: Examples are Novartis exchanging its Vaccines and Consumer business for the oncology portfolio of GlaxoSmithKline and selling its Animal Health business to Eli Lilly, or Pfizer looking to integrate AstraZeneca,” Anand said.
“These cases show a determination for each business to play to areas of specific strength where additional scale can improve returns and organic growth prospects and reflects a move away from looking simply at scale at the overall level.”
“For US companies in particular, surplus cash on balance sheets is viewed by many investors as being unproductive capital.”
“As it becomes increasingly clear that the probability of a strong, broadly spread upturn in end demand is low, it makes sense that management teams focus on capital allocation as the way to develop within their industries.”
“Interestingly, we may see fewer large-scale outright acquisitions as we saw in the last cycle, but instead more streamlining and refocusing of business which should yield good outcomes for shareholders. In most cases, this makes the take-over of divisions as opposed to overall groups more attractive. “
