Monday, January 9, 2017

Absolute Return Partners Chief Investment Officer: U.S. Stocks Have Become Too Costly For Mergers and Acquisitions

Not rational M&A anyway. Vanity deals at 20x EBITDA, sure.

From the January Absolute Return Letter via ValueWalk:

January 2017 Hiccup of the year? 

“ What the New Year brings to you will depend a great deal on what you bring to the New Year. ”-Vern McLellan
The most outrageous predictions of 2017 
Saxo Bank of Denmark ( a bank I hold no grudges against, so don’t assume I am on a mission here ) have in recent years been high on entertainment value when publish ing their now (in)famous list of Outrageous Predictions for the year to come, some of which are highly controversial . The 2017 list , which you can find here , contains the usual mix of more plausible predictions combined with some truly outrageous ones. Amongst their 2017 predictions, I find the following particularly thought - provoking :

1. The  high yield default rate exceeds 25%.
2. Brexit never happens as the UK Bremains.
3. Italian banks are the best performing equity asset.

I am not into making outrageous predictions myself but, if I were, and given the fact that I have a rather wicked sense of humour , my outrageous prediction # 1 for 2017 would probably be for either David Cameron or Hilary Clinton to participate in the 2017 edition of BBC ’s flagship entertainment show Strictly Come Dancing . As Ed Balls just learned, that particular show provides an excellent pla tform to resurrect a fading political career (he probably got more votes for his dancing skills than he did in the last parliamentary elections, but that is an altogether different story). Having said that, only last month did I promise not to make fun of politicians anymore, so let’s drop the ball right there.

Even if 2017 is not likely to be particularly high on entertainment value , it could certainly be high on drama , which makes this Absolute Return Letter particularly challenging. As you may recall from previous years, the January letter is always about the mine field laid out in front of us. What could cause 2017 to be a year to remember? What could possibly go horribly wrong? At t his point in time, I see many potential problems . I have some con cerns about the US . I see dark clouds gathering over Europe , and I see very slippery conditions in many e merging markets (‘EM’) . In other words, lot s of markets around the world appear to be accident prone b u t for very different reasons , which I shall get back to in a moment.

A flicker of good news
However, before I go there, let me share with you a glimmer of hope; a twinkle of optimism that you don’t find too often in the Absolute Return Letter. Not that I am a born pessimist – actually far from it. I just learned many moons ago that, when it comes to investing, good news is the last thing you should spend your energy and resources on. The secret to being a good investor is to focus on risk management and to be well prepared for bad news.

Long term readers of the Absolute Return Letter will know that I have always been of the opinion that we have never properly exited the global financial crisis (the ‘GFC’) of 2007-08. One of the conditions I have used to make my point is the high correlation between risk assets, and how life as an investment manager has become complicated as a result of that.

Prior to the GFC, you could fairly safely assume that diversification across a number of risk assets would dramatically reduce the overall volatility risk, but not anymore. The GFC changed how risk assets correlate with each other (chart 1), and when the correlation between risk assets approaches one, diversification does little to reduce the overall volatility risk.
Absolute Return Letter Interest Rates
Now the good news – it looks as if the correlation between risk assets – or at least between different types of equity risk – is finally coming down (chart 2). As you can see, the correlation between the S&P 500 and the average equity sector has fallen quite dramatically over the last six months. This is not the only dynamic that needs to change for me to become more optimistic, but it is an important one. Expect me to dig deeper on this topic at some point in 2017.
Absolute Return Letter Interest Rates

Growing nationalism

As we enter 2017, what should we worry most about? One factor appears to be standing out head and shoulders above everything else, and that is what is usually classified as growing nationalism. It forced the UK out of the EU, and it got Trump elected in the US, but I am not even convinced that the true driver is just growing nationalism.

As you may recall, national income is ultimately shared between capital and labour, and I think capital has belittled labour for too long by taking an ever larger share of national income. Frustrated by the stagnation in living standards, the man on the street wants something to change. The decision to vote for Brexit (or Trump) was a plea for change, as much as it was a sign of growing nationalism. When your own living standards are under pressure, the last thing you want is an army of immigrants to come in and put you under even more pressure....MUCH MORE (ValueWalk)
Here's the letter as hosted at Absolute Return Partners. (10 page PDF)
The headline point is taken from page 4 of the PDF:
...Take chart 4a (price/EBITDA). When acquisitions are made, most companies are acquired at valuations well below 10x EBITDA. If the average company in the S&P 500 now trades at 11x EBITDA, interesting M&A deals are likely to be few and far between. Companies on the acquisition trail simply cannot justify to pay 12x, 13x or even 14x EBITDA for their acquisition target, removing an important pillar for higher equity prices.
If Interested we linked to Saxo Bank's Predictions 2017: Britain Remains In EU; Mexican Peso Soars, Italian Banks Best Performing Equity Group... in early December.