Shrinking Takeover Premiums Show Bearish Case in U.S. Stocks

  • Takeover targets getting smallest boost to shares since 2007
  • Acquisition offers shrink as valuations have less room to grow

The biggest wave of takeovers ever to sweep the U.S. is failing to ease investors’ anxieties about rising stock valuations.

While a booming market for mergers and acquisitions is often viewed as good
for equities, the impact may be diminishing. Caution can be seen in how much the stocks of takeover targets rise the day after deals are announced. In 2015, the average increase is 16 percent, the smallest gain for any year since 2007, according to data compiled by Bloomberg on deals of at least $200 million. Share price reactions are closely tied with the premium companies are willing to offer, which is also at its lowest since 2007.

Smaller premiums can be construed as a bearish signal on valuations, where even the most motivated purchasers are starting to show reluctance toward lifting stocks too far above current levels. The resistance comes at an ominous time: the Standard & Poor’s 500 Index remains near the same level where it began the year just as price-earnings ratios are widening as profits decline.

“We’re seeing a record M&A year right now, which is something we observed in 2007, and premiums are lower, which we also saw in 2007,” said Marc Zenner, co-head of corporate finance advisory at JPMorgan Chase & Co.’s investment banking unit in New York. “Today M&A is very strategic and there are some pretty important differences between now and then, but based on those two factors you could see a rationale for some kind of correction.”

After climbing 1.5 percent in 2015, the S&P 500 is valued at 18.7 times annual profits, compared with 16.6 over the past 10 years. Price-earnings ratios for S&P 500 companies have expanded by almost 70 percent during the bull market that started in 2009, while valuations tied to sales are the highest since just after the dot-com bubble burst in 2000.

The S&P 500 rose 0.1 percent to 2,091.64 at 9:51 a.m. in New York, after rising 3.3 percent last week, the most since last December.

Typically when a deal is announced, few stocks go straight to their takeover price, reflecting everything from regulatory concerns to skepticism about financing. But shares of companies being taken over are also posting smaller gains as the offering prices tend to shrink when shares are already high. The average takeover premium this year is 28 percent, the smallest since 2007, when it was 23 percent. The highest spread in the past decade was an average of 41 percent, reached in 2009.

“In the past 12 to 18 months M&A has really ramped up, so then it becomes a question of whether the acquirers are being as aggressive and setting high acquisition prices,” Kevin Mahn, president of Parsippany, New Jersey-based Hennion & Walsh Asset Management Inc., said in a phone interview. “The market is fairly valued or somewhat overvalued. They don’t have to be quite as aggressive so the prices don’t have to be as high.”

A merger between Willis Group Holdings Plc and Towers Watson & Co. in June resulted in a 3.3 percent boost to Willis Group’s stock, while Towers Watson’s slid 9 percent on the day. The two traded at multiples as high as 22.8 and 26.2, respectively, in the week prior to the announcement. In the case of Hyperion Therapeutics Inc., the shares had already rallied 85 percent in the three months before Horizon Pharma Plc announced a purchase in March, leading to a 7.6 percent jump in Hyperion’s shares.

In July, Centene Corp. announced it would buy Health Net Inc. in a cash and stock deal valuing the company 21 percent above its trading price at the time. Health Net’s gain was just 10 percent, while the average move among takeover stocks in 2015 has been 16 percent. That’s down from 19 percent last year. In 2011, target companies got a single-day boost of 23 percent on average.

“After you’ve had a market up for quite awhile here companies should be logical in terms of what they’re willing to pay,” said Larry Pitkowsky, co-founder and co-managing partner at Goodhaven Capital Management LLC, where he oversees $450 million. “It doesn’t mean bad deals are done but by a whole host of traditional valuation metrics stock prices look on the high side of fair value.”

Press coverage of possible deals before an actual announcement can also narrow the potential for share gains. Even so, target company moves following such media reports are the smallest since at least 2011, according to Bloomberg data. In June, a report that Anthem Inc. would bid for Cigna Corp. sent the stock up 12 percent, elevating the price to 21 times earnings. When the official bid was announced a month later, Cigna shares fell 5.6 percent and have dropped another 9.3 percent since.

St. Jude Medical Inc., which traded at a price-earnings ratio as high as 19 in the week before an Aug. 27 report of a potential buyout by Abbott Laboratories, rose as much as 5.8 percent on the news before paring the gain to 4.5 percent after the companies said no deal was imminent. Strategic Hotels & Resorts Inc. jumped 3.5 percent in July after reports it was seeking a sale -- in September, the company agreed to a buyout by Blackstone Group LP at a 3.4 percent premium to its 30-day average price.

Reactions this year have been muted in the acquiring company’s shares as well. Acquirers are posting an average gain of 0.5 percent the day after a deal is announced, compared with a 1 percent gain in 2014, the highest on record, according to Bloomberg data going back to 2007.

None of this means acquirers are backing away from the U.S. stock market. With 8,751 deals announced this year worth $2.4 trillion, 2015 is on pace for the biggest year for transactions on record, according to Bloomberg data going back to 2003. That partly reflects a spate of large deals, including Charter Communications Inc.’s $55.1 billion acquisition of Time Warner Cable Inc. On Monday, Pfizer Inc. agreed to combine with Allergan Plc for a deal valued at $160 billion. Both shares fell at least 2.6 percent.

“It’s hard to generalize what can affect how a stock jumps,” Keith Moore, an event-driven strategist at FBN Securities Inc. in New York, said by phone. “These days a lot of companies announce strategic review processes which ultimately lead to a deal being announced, or people leak information to the media and you get the market effect.”

Share price reactions in targeted companies can also be affected by the likelihood of a competing offer at a higher price. With credit spreads widening and an interest rate hike nearing, the potential for competing bids to lift share prices could fade, according to Scott Houlihan, a merger-arbitrage research analyst at OTA LLC.

“With interest rates going up, there could be a slowdown in the credit cycle that would affect all this too,” Houlihan said in a phone interview from Purchase, New York. “If a stock’s jumping after an announcement because they think there’s another bidder out there and now it’s not so easy for someone to finance a counter-bid, the whole M&A cycle could be getting extended.”

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