[Mb-civic] Buttonwood Billion Dollar Babies

Wed Feb 2 15:17:33 PST 2005

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Buttonwood

Billion Dollar Babies
Feb 1st 2005
>From The Economist Global Agenda

A flurry of big acquisitions and better-than-expected corporate profits has
heartened a dubious stockmarket recently. Don¹t break out the champagne yet

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BUTTONWOOD is beginning to feel like a time traveller. When she last shook
the dust of London from her feet, Citicorp and Travelers were just merging.
It was a dramatic moment, not only because it produced America¹s largest
financial-services firm but also because it seemed to herald a more general
revolution in the sector: cross-selling banking, insurance and securities in
a way that regulation, soon to be changed, had largely prevented. She
returns, and within weeks Citigroup is selling the last bits of Travelers to
MetLife, a life-assurance company. Bancassurance American-style apparently
did not flatter banks¹ returns.

This is only one of the multi-billion-dollar deals announced in recent days
that helped to lift American share prices from their week-on-week doldrums
during the first month of the year. On Friday January 28th, Procter &
Gamble, a big consumer-products firm, said it was planning to buy Gillette,
ditto, for about $57 billion. A string of big buyers, actual and potential,
then popped brightly out from the woodwork, mainly in communications,
publishing and the media. Most of the firms in the S&P 500 have now
announced fourth-quarter earnings and most of these, in turn, were higher
than forecast. The granddaddy of them all was ExxonMobil¹s massive $8.42
billion after tax.

Thanks to all this, the S&P 500 index climbed out of its week-on-week
doldrums and managed to finish the month just 2.5% down on its December
close. There are those who set great store by January share-price movements,
holding that as goes January, so goes the year. Buttonwood is not a
particular fan of ³the January effect²: what matters for share prices‹or
ought to‹are the discounted value of a company¹s future earnings and the
relative attraction of other investments. But given all there is to ponder
these days in both stock- and bond markets, the January effect may be as
good as anything to go by.

To begin with, what are we to read into this new wave of mergers and
acquisitions (M&A)? Some $136.6 billion-worth of deals involving American
firms was announced last month, according to Thomson Financial, a research
firm‹$187.9 billion if foreign deals are included. December was a big month
too, with $147.5 billion in American and $307.7 billion in worldwide deals
announced. Why this rush of blood to the head? And what does it mean for
share prices?

The first question is easier. The slump of 2001-02 is over. The memory of
Enron and WorldCom is beginning to fade, and corporate shame with it.
America has kept consuming despite the threat of terrorism. Companies have
cut costs and put their balance sheets in order, many of them buying back
hefty dollops of their own shares. Margins are high: corporate profits in
America last year were running at around 10% of GDP, nearly a record. And
cash is plentiful: S&P 500 companies alone had almost $600 billion in cash
and short-term assets in their coffers last year. That could increase,
thanks to a weird one-off tax break for companies with operations abroad.

Dynamic firms are now looking to consolidate their position within their
industries and find ways to grow. Refocusing can take different forms, and
not everyone is buying. Citigroup, after all, shed its insurance business
and is coy about saying what it plans to do with the roughly $2 billion it
will be left with in exchange. American Express too, on February 1st,
announced that it planned to shed an operation that seemed a poor fit. More
firms are likely to divest as well as to acquire.

What the merger wave means for share prices is harder to say. Big
acquisitions usually give a fillip to stockmarkets because they indicate
confidence in the future and suggest that other companies may be bought at
attractive premiums. Investors should keep an eye out for upward drift in
the premiums that cash-rich acquirers are willing to pay, as they would be a
sign that too much money is chasing too few targets. The deals being done
now are at premiums far below the 30-50% seen in the merger wave of the late
1990s. But they are not insignificant. Gillette¹s shareholders will get
about 18% more than their shares were worth the night before the deal was
announced.

Different messages

The conundrum that is exercising Buttonwood¹s mind at present is different:
are bond markets and stockmarkets living in the same country these days? How
can low, flat bond yields be telling us that all is well, with lowish
inflation and interest rates here to stay, while share prices that keep
failing to break upwards signal that equity buyers are in fact uneasy about
the future? Though shares are slightly overvalued compared with historical
price/earnings ratios, they remain undervalued compared with bonds.

The broader point, however, may be that investors in both markets have grown
complacent during what has been essentially a 20-year bull market in
financial assets. Low inflation and low interest rates have been around for
a long time, but they will not be with us forever. And here the economic
arguments, well rehearsed elsewhere, roll up.

While opinions differ as to degree and timing, America¹s economy will grow
more slowly this year than last. Evidence from the slower-than-expected
fourth-quarter growth of last year was echoed, tentatively, by an Institute
of Supply Management survey released on Tuesday. It showed that factory
activity slowed in January, and by more than had been predicted. Again,
opinions may differ as to whether the Federal Reserve¹s key interest rate
will hit 3.5% or 5% by year-end, but the fact is that it is heading
upward‹few doubt that the Fed will raise interest rates by a smidgeon on
Wednesday. The same is probably true of inflation.

None of this is dramatic stuff‹nothing like as dramatic as America¹s vast
fiscal and trade deficits‹but it all bears watching. Look for a modest
single-digit increase in share prices over the year unless the M&A wave
swells sharply. Clint Eastwood¹s ³Million Dollar Baby² is a great film, but
it doesn¹t end happily.

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