The Deadly Urge: Proof That Mergers and Acquisitions Kill Investor Returns
Businesses should know better: Acquisitions and mergers not only fail to create shareholder value, they actually destroy it.
It’s not a new discovery, either. Peter Lynch, a legendary mutual fund manager, knew this over 20 years ago, when he wrote in One Up on Wall Street:
“Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated ‘diworseifier’ seeks out merchandise that is overpriced, and completely beyond his or her realm of understanding. This ensures that losses will be maximized.”
As I’ll show you, Lynch is spot-on. But it’s even worse than that, because it turns out that the problem isn’t just limited to acquisitions motivated by diversification. Instead, no matter what the motive, acquisitions and mergers are nearly always a terrible move.
Still, mergers and acquisitions are chugging along, with $592 billion in buyouts announced so far this year. Whatever drives the decision-making process leading up to these acquisitions – in some cases it could be a power-hungry CEO or a foolishly over-confident board – the common shareholder is going to end up with poor results nine out of 10 times.
We knew this anecdotally all along, but now it’s been proven…
The Winner’s Curse
Numerous studies have tried to statistically tie acquisition activity to poor returns, but it’s been difficult to prove, as there are often complicating factors that make it difficult to separate causes from correlations.
For example, a clever CEO might buy other companies when their own stock is valued too highly (since acquisitions are often paid for in stock). In that case, however, the acquisition itself might not be the cause of subsequent poor performance, but rather just an indicator that the stock was about to fall anyway (since it was overvalued to begin with).
But a new working paper by Ulrike Malmendier, Enrico Moretti and Florian S. Peters uses a novel approach to isolate the effects of acquisitions and determine what they do to share prices.
At the base of their research is the common concept in economics called “The Winner’s Curse”: If you’re bidding in an auction and you win, that means you valued the object more than any of the other bidders, which, in turn, implies there’s a good chance you mistakenly overvalued it and overpaid.
This new study extends the Winner’s Curse to analyze acquisitions. It looks specifically at those corporate mergers in which there was another bidder competing to buy the same target company. They then compare the returns of the winner, who got to buy the target company, and the loser, who didn’t.
Using these competing companies for comparison makes sense, because it gets rid of so many of those complicating factors. Consider, for example, a natural gas company that’s up for sale. It probably has two larger natural gas companies trying to buy it. Since natural gas companies usually have a similar structure and face the same market conditions, barring other differences, their stock performances are likely similar, as well.
The data in the study confirms that all these similarities hold true in the research. The companies entering purchasing bids do indeed have similar stock performance, earnings estimates and price-to-earnings ratios prior to the acquisition.
So by pairing up these competing bidders, we now have a point of comparison to try to determine exactly what would have happened to the winner’s stock had it never acquired the target company.
It turns out that the returns of the winner and the loser vary widely. The cumulative underperformance of the winner comes out to between 48% and 53%. So when it comes to acquisitions, it turns out that winning is actually losing…
The study also provided an explanation for the regular underperformance of winning companies: As the winners of the bid need to take on more debt in order to make the acquisition, the market punishes this by driving down its stock price.
But again, regardless of the reasons for why these acquisitions occur in the face of historically bad performance, it’s obvious that acquisitions and mergers almost always kill investor returns.
Bottom line: Trying to figure out what acquisitions are smart and which are dumb isn’t easy, so you have to be appropriately critical, as this study clearly shows. By having a very high standard of proof, you can dodge merge-happy stocks and avoid the shareholder pain that foolish mergers and acquisitions cause.
Ahead of the tape,
Matthew Weinschenk
Related Topics: Stocks, Think Contrarian
