THE traditional sharemarket boom cycle goes like this: first stage — interest rates fall, market wakes up and rises strongly; second stage — earnings growth kicks in, companies consistently outperform profit forecasts, sharemarket rises steadily; third stage — takeover boom, followed by sharemarket's final spurt, as earnings growth is harder to come by and CEOs need to make acquisitions to keep getting paid in the manner to which they have become accustomed.
We are now entering stage three — which doesn't mean it ends tomorrow, although there are a few peak-of-cycle signs around, for example Macquarie Bank's willingness to sell something and the three-day five-bagger uranium prospector Toro Energy (25¢ to $1.40 since listing last Thursday). But don't be fooled — this is not the final stage of the boom.
Merger mania is upon us because the world is awash with money and because it's an easy way for CEOs to get some growth, or at least to disguise the lack of it. In many cases, for example Tattersall's and UniTAB, it is just an index play — becoming bigger to climb the index rankings and get a higher rating.
It's not just happening in Australia — far from it. A London fund manager estimates that half of the companies in the FTSE 100 index are now involved in a takeover or are widely expected to be soon. A European strategist told me he expects an explosion of M&A activity in Europe in 2006, as companies look to extract cheaper production costs from the emerging Eastern European countries, and the big brand owners look to consolidate their market power across Europe.
But the key to the global burst of takeover activity is capital cost — corporate debt spreads are as low as they have been for a generation because risk is being underpriced on top of historically low bond yields.
For example, the US corporate BBB 10-year spread over Treasuries is down to 70 basis points, from 300 points two years ago. For emerging markets the decline in spreads has been even more dramatic — from 1000 points (10 per cent ) three years ago to not much more than 100 (1 per cent ) now. So, while investors are being underpaid for the risk they are taking, the risk takers of the world are being overcompensated — they're being given very cheap capital with which to take risks.
As a result, many takeovers can now be self-funding. Graham Harman at Citigroup estimates that half the companies in the ASX 200 index could be acquired using 100 per cent debt and still be self-funding because their earnings yield after tax and interest is above the cost of corporate debt.
It is enormously appealing for a CEO to make an "earnings accretive" takeover that creates greater scale, improves its position in the index and the demand for its stock, and therefore, the CEO's annual bonus.
Equity capital is often an even more attractive takeover currency because of high price earnings ratios at present. That is why so many of the current takeovers are all or mostly scrip swap offers. Directors are signalling that they believe their share prices are high, if not overvalued.
As for the specific takeovers announced this week, the combination of the ASX Ltd and the Sydney Futures Exchange makes sense in the same way that any creation of an impregnable monopoly makes sense for its owners. Whether it should be permitted without some undertakings or price controls is another matter. And the idea of a two-way break fee ($11 million each) seems ridiculous to me.
And it looks a bit like UniTAB directors have sold their recommendation to Tattersall's too cheaply, presumably because anyone other than Tabcorp and its CEO Matthew Slatter is to be welcomed and provided with cups of tea and warm smiles. Slatter and his team will now burn the midnight oil to calculate whether a counter offer makes sense. At least he can get synergies by creating a national TAB network, unlike Duncan Fisher at Tattersall's.
So does the apparent maturing of the M&A part of the cycle mean that the sharemarket is about to head south? No — if anything, the opposite will happen, for a while. In my view, global sharemarkets are not near a peak: the US market is about to get a new lease on life as the Fed's tightening cycle ends, while Europe and Japan are at the beginning of powerful bull markets.
In Australia, the market has run a long way and small stocks with nothing but hope, like Toro Energy, are going off like rockets. But the bears have not capitulated yet.
In my view, there will be no "blow off" in the sharemarket, and therefore no crash, until there has been a capitulation by the bears — in particular by those investors who refuse to accept that spot commodity prices should be used for their resource company earnings forecasts.
The share prices of BHP Billiton and Rio Tinto have tripled in three years to $27 and $78 respectively, yet most analysts still use much lower commodity prices than those prevailing now to value them. Goldman Sachs JBWere this week put out a note hypothetically valuing them using spot prices instead of their own commodity price forecasts: BHP Billiton comes in at $39.99 and Rio Tinto at $101.64 — 50 per cent and 30 per cent higher respectively.
Either commodity prices will collapse soon (very unlikely), or the bears will buckle under the pressure of missing the unstoppable rise of the largest stock in the market and buy in a panic. That panic, when it comes, might be an opportunity to sell a few to the losers who missed the first 100 per cent of the rise.
