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The 80/20 rule — also known as the Pareto principle after the Italian economist who wrote about it more than a hundred years ago — refers to a small number of causes having outsized outcomes.
Vilfredo noticed a fifth of the pea plants in his garden bore most of the fruit and 80 per cent of land was owned by 20 per cent of the population. Anyone who has ever been employed knows the score. Just a few people do most of the work.
It’s the same with financial analysis. Only a small number of inputs is required to have a firm hold on the output. Especially mergers and acquisitions. Basic maths and the back of a cigarette packet? You’re set.
I say this as there has been lots of M&A news this week. My portfolio cannot own individual stocks but most of my readers do. Many of you have emailed to ask my opinion of the deals.
On Wednesday this newspaper reported on the megamerger between ConocoPhillips and Marathon Oil, one of the many in the sector this past year. Such deals are why I own an energy ETF.
Also this week, the board of the UK company which owns Royal Mail agreed to a £5.2bn takeover by its largest shareholder. And the tussle between global mining heavyweights BHP and Anglo America is constantly in the headlines.
So here’s an M&A cheat-sheet for shareholders of acquirer and acquiree companies alike. What to focus on, what to ignore and how to do some simple calculations that will get you 80 per cent of the way to knowing whether to support a deal or not.
Let’s say you own a stock that is suddenly the focus of a takeover bid. This is the much easier side of any deal to consider. Why? Because it is almost always the case that accepting the offer makes sense. After a bit of haggling, of course.
The board and chief executive of a target company will say the price “significantly undervalues” its worth — as those at Anglo American have, for example. You should be sceptical. Markets are generally efficient. A company is worth what it was worth the day before an approach.
Hence ignore any claim that an offer does not reflect the “upside potential” of the acquiree’s business — a higher copper price for example. It’s already discounted. Management has to come up with a good reason why value now abounds that wasn’t visible before.
Companies can be undervalued — of course they can. Customer demand or product prices may rise more than the market expects. But it’s no sure thing, quite the opposite in fact. Otherwise, the target’s share price would have been much higher.
Likewise, don’t believe existing managers when they say they can unlock hidden value. Why trust them? They had a strategy (which underdelivered, hence the bid) and clearly lacked the imagination to change tack earlier.
Surprise offers can jolt companies into action. Anglo’s response that it will eviscerate itself deserves credit. But in theory you can bag the premium paid by an acquirer and then demand a similar action subsequently, assuming you receive shares as well as cash.
Are there legitimate reasons to spurn an offer? Yes, especially if the premium offered doesn’t reflect a loss of control plus a substantial share of the savings that are likely to be generated when the two businesses are bashed together.
Complexity is another red flag — as are too many unknowns. This was the problem with BHP’s bid for Anglo. Targets can never know the counterfactual (would we have done better alone?) but moving parts should at least be kept to a minimum mid-transaction.
Let’s now turn to analysing a deal if you own shares in the aggressor company — the BHP or Conocos of this world. Again you need to dismiss a lot of hogwash. It’s also time to get your pen and napkin out.
There are many justifications for buying another business. Maybe to nab a crown jewel (BlackRock/iShares) or stifle competition (Facebook/Instagram). Sometimes these are bargains in hindsight, sometimes not (Microsoft/Nokia).
But only one reason to pounce on a company always makes sense. And we know this rarely happens because academics constantly remind us that M&A is value destructive to the acquirer, on average.
It is not diversification. Shareholders can do that more cheaply themselves. It’s not cross selling either (Disney/Marvel being one eye-popping exception). Nor is it hoping a target is undervalued (see market efficiency point above).
No, companies should only purchase each other if the value of the costs ripped out exceeds the premium paid. This might be done by consolidating brands, sharing facilities or having just one legal team.
How can you know? First, subtract the share price of the target company before the bid was made public (or use an average over a few months if you suspect a leak) from the offer price. Then convert into real money by multiplying by the number of shares.
That is the value in dollars or pounds of the premium being paid. Next find the estimate for annual cost synergies and adjust downwards either for good measure or because you reckon the aggressor company is smoking dope.
Because these savings are in perpetuity (in theory) you need to apply a multiple to them. A blanket 10 times to be conservative is fine — which is how the Lex column rolls. Or if you want to be snazzier use an average p/e multiple of the relevant sector. Finally subtract corporation tax — 25 per cent or whatever.
If those “capitalised synergies” are less than the premium offered, urge your company to abort. If they’re more, a deal may just be worth it. Easy-peasy — right?
The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__
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