BT: Investors, companies lack common sense (13 Sep 2008)
SHOW ME THE MONEY
Investors, companies lack common sense
They tend to go on a shopping spree when prices are high, and they top up their purchase prices with bigger premiums than in less exuberant times
By TEH HOOI LING
SENIOR CORRESPONDENT
COMPARED with August last year, companies listed on the Singapore Exchange are on average 43 per cent cheaper. The median fall in price is 47 per cent.
If the stock market is a supermarket and things in the supermarket are going for half price, I bet the supermarket will be jam-packed with shoppers.
Alas, this is the stock market and it has a certain kind of perverse logic to it. There'll be buyers galore when things are expensive. But when things are dirt cheap, nobody is interested.
Perhaps you think these are the actions of foolish retail investors who don't know any better. Well, even companies behave in the same way.
They tend to go on a shopping spree when prices are high. In addition to the already high prices, they top up their purchase prices with bigger premiums than in less exuberant times.
See the accompany charts for evidence. As the dotcom bubble was growing in 1999 and early 2000, global mergers and acquisitions (M&A) deals increased steadily. Then the bubble burst, followed by the terrorists attacks in the US and then the outbreak of Severe Acute Respiratory Syndrome or Sars and then the Iraq war. Asset prices globally languished, and so did M&A deals.
That is until the market rebounded in 2004. The three subsequent years of bull market were accompanied by ever-growing numbers and value of M&As. Last year, globally 32,874 M&A deals worth a whopping US$4 trillion were in the works. That's up 15 per cent and 14 per cent respectively from 2006.
But since the sub-prime crisis in the US erupted, deal flow has also dried up significantly. So far this year, total M&A deals announced numbered 19,640, worth US$2.1 trillion. The first eight months showed that the number of deals has fallen by 16 per cent, while the total value has shrunk by an even sharper 34 per cent compared with the same period last year.
Obviously, financial assets such as stocks and shares are different from supermarket goods. They don't have any practical immediate use and people only buy them when they have spare cash. This largely explains why there are more buyers when it is a bull market. Everybody is rich! And vice versa.
Similarly for companies. In addition, companies have the option of using their shares as a currency, that is paying for their acquisitions with their shares in a bull market.
A mistake
It is commonsensical that to make money, one should buy low and sell high. But companies generally have a tendency to do the opposite. In its recent book, The Granularity of Growth, business consultant McKinsey created a database of roughly 200 global companies and tried to decompose the most important sources of growth for each company and market segment. Growth could be from market momentum, mergers or market share gains. They then identified segments that had experienced significant upturns or downturns and looked at the strategies which companies adopted during those periods.
Two sets of results stood out, the consultancy said. First, of the potential strategic moves companies that can make to grow in a downturn - divest, acquire, invest to gain share - an aggressive acquisition strategy created the most most value for shareholders. During an upturn, divestments created slightly more value than acquisitions. This fits the common-sense approach of buying low and selling high.
However, the second finding was that companies often behave in counter-productive ways. There were twice as many companies which made acquisitions during periods of economic growth than in downturns. Significantly, more divested businesses in downturns than in upturns. In other words, companies were likely to buy high and sell low rather than the other way around.
All these are understandable, noted McKinsey. As revenues slow and margins get squeezed, management naturally switches its focus to cutting costs and maintaining earnings. The company protects its balance sheet, which in practical terms means deferring growth and low-priority investments, shelving large acquisitions, and selling assets.
Many companies simply freeze: 60 per cent of those in its database made no portfolio moves at all in downturns, compared with only 40 per cent that made no moves in upturns, the consultancy found.
The best growth companies, however, take a different approach, noted McKinsey. 'They view a downturn as a time to increase their leads and make acquisitions. They pounce on opportunities it creates with an alacrity that is the stuff of legends: think of General Electric's speedy dispatch of an army of deal makers to Asia after the financial markets took a downturn in 1998.
'We are not saying companies should go on a spending spree in a downturn and tighten their belts in an upturn. Nor are we unaware that some companies simply aren't in a financial position to exploit the opportunities that downturns present. But for large numbers of healthy companies and their CEOs, we hope our research findings are a useful counterweight to the natural tendency, which is likely to harm shareholders.
'Simply put, counter-cyclical investment can separate the leaders from the also-rans. Arguments that growth is risky in a downturn overstate the case,' McKinsey said.
So in the next 12-24 months, I'll be keeping a lookout for conservative cash-rich companies which embark on sensible acquisitions.
Next week, I'll take a closer look at global M&A deals. For example, of all the deals announced in a particular year, how many actually get completed? Do we have more cash deals in down markets? And do cash deals have a higher chance of being completed? And perhaps the premiums paid for acquisitions over the years. I'm looking forward to doing the analysis!
Meanwhile, last week's article 'Who to trust? Sell-side or buy-side analysts?' struck a chord among investors in the current gloomy market. One reader said that it was a timely article and added that 'if there was a 'parallel of corporate governance code/legislation' for the analysts and company research industry, many of them would have gone to jail many times over'.
Another noted that up to now, he still cannot figure out how analysts crunched their numbers. 'The dynamics of global economy have changed dramatically,' he said. 'Earnings are a lot more volatile. Even companies with all their inside knowledge have problems forecasting their own earnings and have to resort to creative accounting and short-term strategies to ensure earnings target are met.
'So, how can an analyst, no matter how brilliant, accurately forecast earnings?
'In my view, the analyst's work is a lot of guess work. The situation is quite comical. Analysts forecast x earnings. Actual earnings came in below expectation. Analysts downgrade earnings forecast. I now read analysts report, more for amusement than insight.'
Another reader said that he used to work as a sell-side equity analyst in Singapore for many years before crossing over to asset management two-and-a-half years ago.
'I just want to point out that the performance criteria in buy-side is different from sell-side,' he said. 'On the buy-side, the value add is not how accurate the earnings forecasts are, but how the analyst helps the fund managers pick stocks.
'It doesn't matter if my EPS (earnings per share) forecasts are off by a mile if the stocks I've picked outperform. In fact, due to the greater coverage universe (60-plus stocks now compared to at most 15 when I was in sell-side), it isn't possible to be that detailed in modelling the company.
'The main function is to stay on top of the great volume of data and information and newsflow that comes through each day and synthesise this to formulate an investment view concerning the stocks in my area.
'An additional comment - many sell-side analysts also cross over to buy-side for greater job security. Securities firms worldwide are very shortsighted and have no hesitation in slashing headcount when times are bad. Very disruptive to your career.'
Thanks all for your e-mails. I think everybody enjoys a healthy, lively exchange of comments and ideas. So keep the e-mails coming! In the meantime, have a good week ahead.
The writer is a CFA charterholder.
Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved
Investors, companies lack common sense
They tend to go on a shopping spree when prices are high, and they top up their purchase prices with bigger premiums than in less exuberant times
By TEH HOOI LING
SENIOR CORRESPONDENT
COMPARED with August last year, companies listed on the Singapore Exchange are on average 43 per cent cheaper. The median fall in price is 47 per cent.
If the stock market is a supermarket and things in the supermarket are going for half price, I bet the supermarket will be jam-packed with shoppers.
Alas, this is the stock market and it has a certain kind of perverse logic to it. There'll be buyers galore when things are expensive. But when things are dirt cheap, nobody is interested.
Perhaps you think these are the actions of foolish retail investors who don't know any better. Well, even companies behave in the same way.
They tend to go on a shopping spree when prices are high. In addition to the already high prices, they top up their purchase prices with bigger premiums than in less exuberant times.
See the accompany charts for evidence. As the dotcom bubble was growing in 1999 and early 2000, global mergers and acquisitions (M&A) deals increased steadily. Then the bubble burst, followed by the terrorists attacks in the US and then the outbreak of Severe Acute Respiratory Syndrome or Sars and then the Iraq war. Asset prices globally languished, and so did M&A deals.
That is until the market rebounded in 2004. The three subsequent years of bull market were accompanied by ever-growing numbers and value of M&As. Last year, globally 32,874 M&A deals worth a whopping US$4 trillion were in the works. That's up 15 per cent and 14 per cent respectively from 2006.
But since the sub-prime crisis in the US erupted, deal flow has also dried up significantly. So far this year, total M&A deals announced numbered 19,640, worth US$2.1 trillion. The first eight months showed that the number of deals has fallen by 16 per cent, while the total value has shrunk by an even sharper 34 per cent compared with the same period last year.
Obviously, financial assets such as stocks and shares are different from supermarket goods. They don't have any practical immediate use and people only buy them when they have spare cash. This largely explains why there are more buyers when it is a bull market. Everybody is rich! And vice versa.
Similarly for companies. In addition, companies have the option of using their shares as a currency, that is paying for their acquisitions with their shares in a bull market.
A mistake
It is commonsensical that to make money, one should buy low and sell high. But companies generally have a tendency to do the opposite. In its recent book, The Granularity of Growth, business consultant McKinsey created a database of roughly 200 global companies and tried to decompose the most important sources of growth for each company and market segment. Growth could be from market momentum, mergers or market share gains. They then identified segments that had experienced significant upturns or downturns and looked at the strategies which companies adopted during those periods.
Two sets of results stood out, the consultancy said. First, of the potential strategic moves companies that can make to grow in a downturn - divest, acquire, invest to gain share - an aggressive acquisition strategy created the most most value for shareholders. During an upturn, divestments created slightly more value than acquisitions. This fits the common-sense approach of buying low and selling high.
However, the second finding was that companies often behave in counter-productive ways. There were twice as many companies which made acquisitions during periods of economic growth than in downturns. Significantly, more divested businesses in downturns than in upturns. In other words, companies were likely to buy high and sell low rather than the other way around.
All these are understandable, noted McKinsey. As revenues slow and margins get squeezed, management naturally switches its focus to cutting costs and maintaining earnings. The company protects its balance sheet, which in practical terms means deferring growth and low-priority investments, shelving large acquisitions, and selling assets.
Many companies simply freeze: 60 per cent of those in its database made no portfolio moves at all in downturns, compared with only 40 per cent that made no moves in upturns, the consultancy found.
The best growth companies, however, take a different approach, noted McKinsey. 'They view a downturn as a time to increase their leads and make acquisitions. They pounce on opportunities it creates with an alacrity that is the stuff of legends: think of General Electric's speedy dispatch of an army of deal makers to Asia after the financial markets took a downturn in 1998.
'We are not saying companies should go on a spending spree in a downturn and tighten their belts in an upturn. Nor are we unaware that some companies simply aren't in a financial position to exploit the opportunities that downturns present. But for large numbers of healthy companies and their CEOs, we hope our research findings are a useful counterweight to the natural tendency, which is likely to harm shareholders.
'Simply put, counter-cyclical investment can separate the leaders from the also-rans. Arguments that growth is risky in a downturn overstate the case,' McKinsey said.
So in the next 12-24 months, I'll be keeping a lookout for conservative cash-rich companies which embark on sensible acquisitions.
Next week, I'll take a closer look at global M&A deals. For example, of all the deals announced in a particular year, how many actually get completed? Do we have more cash deals in down markets? And do cash deals have a higher chance of being completed? And perhaps the premiums paid for acquisitions over the years. I'm looking forward to doing the analysis!
Meanwhile, last week's article 'Who to trust? Sell-side or buy-side analysts?' struck a chord among investors in the current gloomy market. One reader said that it was a timely article and added that 'if there was a 'parallel of corporate governance code/legislation' for the analysts and company research industry, many of them would have gone to jail many times over'.
Another noted that up to now, he still cannot figure out how analysts crunched their numbers. 'The dynamics of global economy have changed dramatically,' he said. 'Earnings are a lot more volatile. Even companies with all their inside knowledge have problems forecasting their own earnings and have to resort to creative accounting and short-term strategies to ensure earnings target are met.
'So, how can an analyst, no matter how brilliant, accurately forecast earnings?
'In my view, the analyst's work is a lot of guess work. The situation is quite comical. Analysts forecast x earnings. Actual earnings came in below expectation. Analysts downgrade earnings forecast. I now read analysts report, more for amusement than insight.'
Another reader said that he used to work as a sell-side equity analyst in Singapore for many years before crossing over to asset management two-and-a-half years ago.
'I just want to point out that the performance criteria in buy-side is different from sell-side,' he said. 'On the buy-side, the value add is not how accurate the earnings forecasts are, but how the analyst helps the fund managers pick stocks.
'It doesn't matter if my EPS (earnings per share) forecasts are off by a mile if the stocks I've picked outperform. In fact, due to the greater coverage universe (60-plus stocks now compared to at most 15 when I was in sell-side), it isn't possible to be that detailed in modelling the company.
'The main function is to stay on top of the great volume of data and information and newsflow that comes through each day and synthesise this to formulate an investment view concerning the stocks in my area.
'An additional comment - many sell-side analysts also cross over to buy-side for greater job security. Securities firms worldwide are very shortsighted and have no hesitation in slashing headcount when times are bad. Very disruptive to your career.'
Thanks all for your e-mails. I think everybody enjoys a healthy, lively exchange of comments and ideas. So keep the e-mails coming! In the meantime, have a good week ahead.
The writer is a CFA charterholder.
Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved
posted by mrmoon at 8:41 PM
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