It is a well-documented fact: merger and acquisition waves tend to coincide with stock market peaks and their immediate subsequent downturns.
The latter phenomenon is fairly easy to understand. After all, in worsening economic conditions, firms can seek to survive through expanding their scale, scope, or market power. Companies that are struggling are also at their most desperate, an advantageous position for a prospective buyer.
But what of the former? What accounts for the apparently obvious bias toward overpaying for acquisitions?
Multiple forces account for this observed correlation in the data.
First, to illustrate why firms making acquisitions at or near stock market peaks are systematically overpaying, consider the technical aspects of a bull market. During periods of expansion, the prices of equities tend to rise relative to their earnings. These growing price-to-earnings ratios (P/E) mean that the price one is paying for an equity’s expected return in earnings is increasing.
Example: If stock X is trading at a P/E of 10, an investor is essentially paying ten dollars for an expected dollar of future earnings. Were stock X trading at a P/E of 100, the investor would be paying a hundred dollars for the expected dollar of future earnings.
Since acquisition prices are based on the prevailing market price of the target firm, by buying at the peak of a market bubble, the acquiring firm is paying a steep premium.
This is borne out in the data, which reveals that acquiring firms tend to produce lower returns in the years following the acquisition. Of course, one could argue, counterfactually, that the acquiring firm’s returns going forward would have been even worse but for the acquisition. And while this is possible, it is also unprovable.
A likely factor contributing to firms’ underperformance following mergers and acquisitions, pointed out by Warren Buffett, is the very simple fact that the best companies aren’t interested in being acquired by anyone else. The pool of companies looking to be acquired, in other words, is likely to be overwhelmingly populated by struggling firms.
Management overconfidence—buoyed by acquiring firms’ success during the bull market—is another noted driver of purchases. Firms with a lot of cash on hand tend to look for some place to spend it. In the process, firms tend to bid up the prices of the already suboptimal acquisition targets.
The winner’s curse, a documented oddity, is that buyers in an auction-like environment are almost certain to overpay. This is based on the assumption that if the average of all the bids is closest to the real value of the thing up for purchase, then the winner necessarily overpays.
The tendency to misspend the large amounts of incoming cash during particularly bullish runs is related to firms’ tendency to buy back their own stock during such periods—again, likely overspending in the process.
While cash buybacks result in no change in a firm’s underlying fundamentals, when firms take on additional debt to finance buybacks, the cost of equity will increase with the firm’s increase in financial risk because of the debt.
When it comes to private sector acquisitions, the increase over the past several years has been additionally impelled by demographic and political concerns. As the latter half of the baby boom generation weighs retirement, many small and medium-sized multimillion dollar enterprises were already being put up for sale. However, with the Democrats having all but lost their minds and populism taking hold among Republicans, fears of a dramatic increase in capital gains taxes is tipping uncertain owners in the direction of selling now rather than face the risk of a huge tax bill.
While the past is not a certain predictor of the future, the correlations observed in the data and the clear ability of human actors to make better decisions by observing the fundamentals of the business cycle suggest that firms aware of these tendencies can optimize their outcomes by behaving more prudently in the face of the expanding credit cycle.
Austrians, understanding that central bank manipulation of real interest rates leads invariably to asset price bubbles, are unlikely to be fooled. As Mises himself noted, “The moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all…. It is precisely in the stock market boom that the serious threat of a crisis lies hidden.”
As Doug French pointed out back in 2011, once the Fed’s mismanagement of the money supply forces it to stop manipulating the bond market, all the new economy valuation models “will be blown up.”
The ongoing saga of Elon Musk potentially buying out Twitter at a price of over $50 per share, or over a hundred times its earnings, if it ultimately winds up happening, is likely to go down in infamy in business textbooks.