June 9, 2011 / 4:32 PM / 6 years ago

Analysis: M&A deals to favor developed stocks over emerging

<p>Karen Olney, Head of Thematic Strategy UBS, attends the Reuters Global Investment Outlook Summit in London June 6, 2011.Benjamin Beavan</p>

LONDON (Reuters) - Cash-rich firms keen to expand are choosing the stagnant developed economy for cheap and high quality M&A targets over the fast-growing emerging world, a factor that could help Western equities outperform.

Merger and acquisition activity is accelerating globally from an already buoyant 2010, with companies making deals worth $244 billion a month this year -- up 45 percent from 2010.

Within this, according to Thomson Reuters data, the share of transactions involving developed economies has risen to 75 percent as of end-May from 67 percent in December.

The increasing share of the developed economy in M&A activity would help encourage investors to rotate further into the developed market stocks away from their emerging cousins.

This shift looks like it is already underway; emerging stocks .MSCIEF are down 1 percent since January, while developed stocks .MIWO00000PUS have risen 1.6 percent.

"Management absolutely want to spend. There's so much cash on their books. A lot of activities are in the pipeline. As we get through the year there will be more money coming back to developed markets partly as there are M&A opportunities," said Karen Olney, head of European thematic research at UBS, told the Reuters 2011 Investment Summit.

"You've got corporate governance issues starting to appear in places like China. Good reliable companies will be a target for companies in Asia trying to improve corporate governance."

This year's underperformance of emerging markets stems from concerns about inflation and political upheavals in the Arab world, but the rush of companies keen to cross-list in fast-growing Asia has also played part.

Companies like commodity trader Glencore (0805.HK) (GLEN.L) and Italian fashion house Prada may have created a wider pool of shares but they also kept the lid on prices.

While new issuances boost market capitalization of emerging markets where the lack of liquidity has been a key issue, the positive impact may be limited.

"(The issuance was) one of the reasons that held the emerging markets back last year... If we were to see a significant recovery we will have quite a supply of stock," said Jean-Paul Smith, chief emerging equity strategist at Deutsche Bank, told the Reuters Summit.

"In theory the market will then be more reflective of GDP. Obviously it depends on the quality of companies which are coming to the market and particularly the quality of corporate governance... Clearly M&A premium goes to developed markets."


Companies in the developed world are sitting on record levels of cash after combating the economic downturn by firing staff, stopping M&A deals and reducing capital expenditure after the financial crisis.

Banks in particular have deleveraged to repair balance sheets after the collapse of Lehman Brothers in September 2008.

JP Morgan's estimate shows corporate financing surplus -- measured by difference between cash flows and spending -- rose to around 3.5 percent of gross domestic product in G4 countries (the United States, euro zone, Britain and Japan) at end-2010, an increase of $1.6 trillion from 2008.

"Corporations have not been shareholder friendly and they pleased bond holders more by cutting buybacks and dividends and stopping M&A as they fought to stay alive," said Alain Bokobza, head of global asset allocation at Societe Generale.

"But companies will lose money on sitting on huge cash... One way to kick start the releveraging process is to start an M&A cycle... it backs developed market equities more than emerging markets. You need to allocate out of credit into equities."

As the economy matures into a mid/late cycle and financial markets cleanse themselves off the leverage overhang, corporates are expected to start actively putting their idle cash to work on capital spending, beyond acquiring their peers. In Europe, UBS expects capital expenditure to rebound rapidly this year from a fall of 15 percent in 2009 -- one of the largest declines on record.

The bank upgraded its 2011 capex growth estimate sharply in April to 9 percent -- 2-3 times the average since 1996 -- from its estimate of one percent made in September.

And investors think there's more room for companies to increase capex. A net 47 percent of fund managers polled by Merrill Lynch Bank of America last month said companies are currently under-investing in their businesses.

Editing by Sophie Walker

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