Merger Mania Markers

Do mergers signal a market top?

Open the business section today and you can’t miss them: acquisition fever seems to jump off the page: Tyson Chicken is bidding for Hillshire Brands; Man group—a UK hedge fund manager—is buying the Boston-based quant firm Numeric; Apple is spending $3 billion for Dr. Dre’s headphone company, Beats. And that’s just today’s paper. Mega-deals are pending in other areas of the market.

It’s not just our perception: global mergers and acquisitions activity surged 23% to over $800 billion in the first quarter of 2014. Many folks claim that merger mania signals trouble ahead: the last time deal-making was this high was the first quarter of 2008. And we all know what happened that year.

Still, correlation does not equal causation. High-crime areas tend to have more police presence, but that doesn’t mean that the police cause crime. Deals may peak at a market top because all financial activity hits a high level. And wacky deals happen because corporations are run by people: they can get caught up in the market’s euphoria as well. Finally putting all that corporate cash to work feels good.

Any time the market reaches a new high people look for explanations, and investors get nervous. But over-valuation is only clear from the subsequent financial statements, and they only come out later. Synergies and cost-cutting may justify the mergers, or they may be management smoke.

The only thing really dependable about a market top is that six months after it happens, everyone claims to have seen it coming.

Douglas R. Tengdin, CFA

Chief Investment Officer

Famous For Being Famous

What makes art great?

The Mona Lisa was a relatively obscure portrait in the Louvre until it was stolen in 1911 by an Italian carpenter, who tried to sell it to an art gallery in Florence. The French were outraged, while Italy hailed the thief as a patriot who wanted to bring the painting home. Newspapers around the world put the Mona Lisa on their front page, insuring its global fame. The image came to represent Western culture itself.

There’s a certain subjective quality to what makes something a classic. Mark Twain’s definition—a book everyone wants to have read, but no one wants to read—rings true. People go to art shows or listen to music or read books because other people think the work has value. After all, who can really tell the difference between the composers Rameau and Couperin?

This has implications for investments, at least in the short run. John Maynard Keynes likened equity pricing to a beauty contest, where we don’t choose the most beautiful contestant, but the one we think other people will think is the most beautiful. So some investors look for “momentum plays,” where a stock is gaining favor and becoming more popular. Eventually, the equity becomes priced to perfection, and falls at the first sign of trouble.

In the short run the market is a voting machine. Sentiment can shift with the winds of fashion. But in the long run, it’s a weighing machine. Quality eventually wins. After all, to become famous, the Mona Lisa had to get into the Louvre in the first place

Douglas R. Tengdin, CFA

Chief Investment Officer

Financial Werewolves?

Can a dog turn into a wolf?

Jack London had a sense of this when he wrote The Call of the Wild. His main character, the dog Buck, returns to a feral state of nature after he is kidnapped and taken to Alaska. When his adopted master is killed, Buck goes wild, eventually leading a wolf-pack.

There are times when people undergo this Jekyll-and-Hyde transformation as well, when they face a novel or uncertain challenge. Their bodies react to the tension, releasing steroids into the bloodstream, which in turn affects their judgment. If they experience repeated success, their hormone levels rise, and they can become addicted to risk-taking, or even become reckless.

We’ve seen this movie before in the financial markets: young adrenaline-junkies are attracted to the action and glamour of the trading floor; they get on the right side of a big market move; and their positions grow and grow until they threaten the very institutions they work for. Heightened testosterone levels may have a lot to do with market bubbles. There’s a reason why all the major trading losses of recent years have been made by men, and mostly young men.

The tragic story of success, overconfidence, and downfall is as old as civilization itself. One way banks can avert it is by having a balance of men and women, both young and old, on the trading floor, along with clear limits and segregation of duties.

Buck may have succumbed to the call of the wild. But people don’t have to.

Douglas R. Tengdin, CFA

Chief Investment Officer

Apologies, Aschmologies

Is saying you’re sorry good for business?

Mary Barra, the new CEO of GM, recently apologized to those affected by their recall of over 2 ½ million small cars for faulty ignition switches. But do such apologies have any meaning? Aren’t they just part of a corporate chess game with regulators, customers, and workers?

Some researchers sought to understand what it means to express regrets in a business context. They looked at what happens when physicians apologize for medical mistakes. It’s an interesting case study, because doctors are often hesitant to apologize because of lawsuits, but patients often sue out of anger because the doctors won’t apologize.

To break this cycle, over 30 states have passed laws that make a doctor’s apology inadmissible in court. The research examined malpractice claims before and after these laws were passed. After the apology-shield was enacted, there was over a 15% reduction in malpractice filings, and the cases settled 20% faster.

Apologies are hard—and that’s the point. Saying you’re sorry exposes you to guilt and shame. But it may be the only way to restore trust after something goes wrong. And the more costly the regrets, the more effective the signal.

Douglas R. Tengdin, CFA

Chief Investment Officer

Wordly Wise?

Watch your language.

That’s what GM’s managers believed. When they settled with the US Government over their bungled ignition-switch recall, they released a lot of internal documents. One was a presentation made in 2008 that explained the recall process to engineers, including how to document faults and engineering issues.

Naturally, management wanted its technical people to be careful about what they said. A lot of the advice is common sense, like imagine how folks would react if they saw your comments in the paper the next morning, and to focus on facts and avoid speculation.

But they went on to list 69 words that should never be used in print—terms like “good” or “problem” or “safety.” It’s understandable that the legal department doesn’t want a careless technician to refer to a product as a powder-keg, but telling someone to replace the term “problem” with “issue” or to change “defective” to “does not perform to design” sounds Orwellian.

I work in a regulated industry; I understand that terminology can have legal implications. Cervantes said that words have meaning, and names have power. But when you have to tell your staff not to compare a car to a grenade, maybe your problem—er, issue—is more than just vocabulary.

Douglas R. Tengdin, CFA

Chief Investment Officer

Bad News or Good News?

Are newspapers doomed?

Ever since the first newsfeed appeared on the web, the traditional newspaper’s current business model was threatened. If you picked up a newspaper 50 years ago, it was filled with a lot of non-news items: real-estate listings, grocery store coupons, want-ads. Those money-making inserts were bundled with a journalistic product that focused on a defined geographic region.

Distribution was limited by the cost of physically delivering this bundle of paper. Gradually, each area developed into a local monopoly, usually with only one major paper per city. So when the internet arrived with newsfeeds and specialized websites for sports or cars or real-estate or job-listings, the news business was turned upside-down. Since 2000, lots of major papers have failed: the Chicago Tribune, the Minneapolis Star Tribune, the Philadelphia Inquirer, and others.

Journalism is now more competitive than it has been in decades. But its principal product—a finely crafted news story—can be distributed to anyone around the world for almost nothing. The New York Times now competes with the Los Angeles Times and The Guardian for readers, and the Frankfurter Allgemeine has a gorgeous mobile app.

The revenues of the news business aren’t drying up. Those rivers of gold are breaking into myriad streams of targeted ads and web subscriptions. As the poet Ovid said: nothing perishes, but all things change.

Douglas R. Tengdin, CFA

Chief Investment Officer

Mega-Merger Madness

“Is that your final answer?”

That was the question that Regis Philbin would ask contestants on “Who Wants to be a Millionaire?” And it’s the question AstraZenica put to Pfizer in the latest pharmaceutical mega-merger. So far, AstraZenica doesn’t like Pfizer’s answer. They want more money.

Mega-mergers are a funny business. Two giant organizations seek to combine operations and bring efficiencies and synergies to their businesses. Efficiencies can often come from combining accounting, finance, and other administrative functions, although that’s not so simple with huge organizations. Synergies come as sales staff can offer related products, encouraging customers to find exactly what fits their needs. But it’s easy to overestimate the benefits. So why are mega-mergers so popular?

In the past two decades mega-mergers have been routine among pharmaceuticals: Pfizer-Pharmacia ($60 billion), Merke-Schering Plough ($40 billion), Glaxo-SmithKline ($70 billion). Unlike many mergers, especially among technology companies, pharmaceutical mergers over this period have typically increased margins and expanded sales, adding to shareholder value.

Part of the reason is in the nature of the drug business. Bringing a new treatment to market is incredibly complex. There are tests and approvals and sales hurdles to overcome that require a lot of capital. As buyers of healthcare have consolidated through government policies and insurance-company mergers, it makes sense that providers would combine as well. And in this case, Pfizer would save billions by switching its home base to the UK, where taxes are lower.

Still, it’s easy to overreach. You can’t blame AstraZenica for wanting more. At some point, though, a high price makes a merger uneconomic. Pfizer has been pretty disciplined in its dealmaking in the past. For their shareholders’ sake, let’s hope they remain so.

Douglas R. Tengdin, CFA

Chief Investment Officer

On Capital and Fairness

“That’s not fair!”

That’s our instinctive reaction when we see people without skill, talent, or hard work get ahead, seemingly at the expense of everyone else. It’s why we root for the gritty underdog in sports contests. And it’s why Thomas Piketty’s recent critique of growing inequality in our economy strikes a chord.

Piketty looked the real net worth of 65-74 year olds in 1990 and 2010 (from a Fed survey) and found that it had grown by 2.8% per year over these three decades—significantly more than the mere 0.7% of the average family. He concludes that these people are benefitting from a high real return on capital, and that in a few years a few families will dominate our economy. We’ll all be wage-slaves for the Zuckerbergs.

To put it simply, this is nonsense. First off, his data suffers from survivorship bias. Older folks’ wealth didn’t grow by 3%–that age cohort got richer, but most of the elderly in the 1990 cohort had died by the time the 2010 group was measured. It’s like measuring the average height of NBA players in 1990 and 2010, finding it was 3 inches higher in 2010, and then concluding that playing NBA basketball makes you grow taller.

Second, nothing makes capital “grow” by itself. Wise investment and hard work can create wealth, just as foolish choices and lavish spending can disperse it. That’s why so few of the richest folks on the Forbes 400 list are there 20 years later. Instead, the list is dominated by entrepreneurs: people who have a great idea and make it part of our everyday lives—like Henry Ford’s automobile, or Sam Walton’s store, or Bill Gates’ operating system. But they don’t stay there forever. There’s an old proverb: “From shirtsleeves to shirtsleeves in three generations.”

Inequality can be a problem when it leads to social disruption—like the race-riots of the ‘60s. But punishing hard work and innovation won’t improve the plight of the very poor. Instead, it will probably make it worse.

Douglas R. Tengdin, CFA

Chief Investment Officer

Game of Phones

Will the phone wars ever stop?

Comcast plans to buy Time-Warner Cable. Vodaphone sold its Verizon Wireless holdings and bought a German cable company. AT&T is close to purchasing DirecTV; Sprint may buy T-Mobil. Tens of billions of dollars are sloshing around. What’s going on?

Increasingly, people expect to watch streaming video wherever and whenever they want on whatever device they have. Providing wireless, cable, landline, and internet in one package reduces billing costs, and increased size means better negotiating power with phone-makers, government officials, and other wireless providers over connections and roaming costs. What’s not to like?

Well, increased concentration can raise antitrust issues. There aren’t a lot of telecom providers. The Justice department blocked a proposed AT&T/T-Mobile deal a few years ago because it would limit competition. If one or two players dominate an industry, innovation suffers and consumers are hurt.

Telecom may be a small part of the economy, but there’s a lot of money at stake in a critical industry. Investors need to be careful: it’s easy for managers to overreach. As Shakespeare said, “Wisely and slow—they stumble that run fast.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Returning to Risk (Part 4)

Why is risk so important?

Risk-management is at the center of rational investing. It’s what keeps people up at night when markets are booming, and what allows them to sleep soundly during panics and depressions. It’s what allows your money to work for you, so that later in life you don’t need to.

But risk-management puts a glaze over people’s eyes. Tell them you work in risk-management and they’ll quickly change the subject. Google the phrase and you’ll get links to wiki articles about engineering problems in the International Space Station and a magazine about insurance.

We’ve seen before how short-term risk is linked to returns through the financial structure of the investments, and long-term risk comes from outside factors like inflation or taxes or economic depression. Short-term risk allows your money to grow; long-term risk tries to take it away.

The genius of the Enlightenment was that men and women are not passive before the forces of nature, but they can first learn how the world works, and then put these principles to work to better their conditions. In the process, great wealth can be created. But government actions or random events or our own foibles can quickly destroy it. Understanding and managing these threats is critical.

Because it’s not what you make, it’s what you keep.

Douglas R. Tengdin, CFA

Chief Investment Officer