ON THURSDAY January 15th Switzerland’s central bank, the Swiss National Bank (SNB), removed the cap on its currency, which it had imposed over three years ago and reaffirmed only three days before its repeal. The doffing of the cap surprised and upset the foreign-exchange markets, hobbling several currency brokers, including Alpari (which happens to sponsor the London football team I support). Many commentators nonetheless welcomed the cap’s removal, arguing that the policy was either unsustainable, protectionist or risky, exposing the SNB to grievous losses. I find these criticisms of the cap unconvincing—and not just because I am a West Ham United fan. Let me address each of them in turn.
Misconception 1: The cap on the Swiss franc was unsustainable
Exchange-rate pegs often fail. To prop up its currency, a central bank might have to buy large amounts of its own money in exchange for dollars or euros. Eventually, it will exhaust its hard-currency reserves forcing it to abandon its peg.
The first thing to understand about the Swiss drama is that it is the exact opposite of this more familiar case. The Swiss central bank was trying to keep its currency down not prop it up. To achieve this goal, the SNB had promised to sell as many Swiss francs as necessary (in exchange for “unlimited quantities” of foreign currency). The promise was credible, because a central bank can print its own currency without limit. It cannot run out of its own money to sell. The cap was, therefore, sustainable if the SNB had wished to sustain it.
If a central bank overworks the printing press, its money will eventually lose value, of course. Inflation and depreciation set a limit on the power of central banks. But the Swiss had imposed the cap precisely because they wanted to raise domestic inflation from dangerously low levels (consumer prices fell by 0.3% in the year to December 2014, according to the Federal Statistics Office). Persisting with the currency cap might have pushed up prices. But that is no objection to the policy; on the contrary, it was the objective of it.
Misconception 2: The Swiss central bank needed to worry about big losses on its euro holdings
The second misconception is less basic. Every economist knows that a central bank cannot run out of its own currency. But many believe the Swiss cap was unsustainable for a different reason.
If the SNB had stuck with its cap, buying as many euros as people were willing to sell at its set price of 1.20 Swiss francs, its holdings of the single currency would have swollen in size. By the end of September 2014, it already held over €174 billion, according to its balance sheet. With the single currency weakening in anticipation of further monetary easing by the European Central Bank, this hoard was likely to grow to epic proportions.
Perhaps because I live in Hong Kong, where the monetary authority’s foreign assets amount to over 120% of the economy’s annual output, big central-bank balance sheets don’t scare me. But others worry. They point out that if the franc were ever permitted to rise against the single currency, the Swiss central bank would suffer an enormous loss on its euro assets. Euro holdings worth, say, 240 billion francs at the capped exchange rate would be worth 40 billion less in the Swiss currency if it rose by 20%.
If the loss were big enough, the central bank’s assets (which include its euro holdings) might end up being worth less than its liabilities (which are overwhelmingly in its home currency). The central bank, known until last week for its quiet conservatism, would be technically insolvent.
That would be a little awkward. It would not be easy to explain the central bank’s predicament to its shareholders, who include the Swiss cantons, or to unsympathetic political parties, such as the Swiss People’s Party—which has already sponsored an unsuccessful referendum to force the SNB to hold at least a fifth of its assets in gold.
But although insolvency is humbling for a central bank, it is far from crippling. “Central banks may operate perfectly well without capital as conventionally defined,” pointed out Peter Stella in a working paper published by the International Monetary Fund back in 1997. Central banks cannot go bust in the way that a commercial bank can. They can always pay their bills, because they print the money they owe.
Their debts are also peculiar. The SNB’s liabilities are chiefly Swiss francs. For the most part, as its balance sheet shows, they take the form of simple banknotes or the deposits that commercial banks hold at the central bank.
The franc, like all fiat money, is not backed by anything tangible. People accept it as payment because they are confident other people (including the tax authorities) will accept it. Try to redeem a banknote at the central bank and all you will get is a newer banknote. That is all that a central bank’s liabilities promise: I owe you an IOU.
These debts are also uniquely easy to service. Banknotes pay zero interest. Deposits at the SNB now yield even less than that: depositors pay the central bank, not the other way around.
Central banks do not, then, have to worry much about satisfying their creditors. Nor are they judged by the returns they earn for shareholders. They are judged by their ability to keep inflation in check and the financial system stable. Their balance sheet—the size and mix of their assets and liabilities—is important insofar as it serves that mission. It is a macroeconomic tool, not a statement of financial success or failure.
The SNB itself understands this. After it reported big losses on its foreign-exchange holdings in 2010 and early 2011, it faced doubts about its financial strength. Some people speculated that it might eventually suffer from negative net worth (also known as “negative equity”). In a 2011 speech, Thomas Jordan, who now heads the institution, answered these concerns directly.
“Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?...[T]he short answer to all these questions is ‘No’.”
If the SNB ever became insolvent, it would not be the first central bank to suffer such an indignity. The Czech central bank and the Bank of Chile, among others, functioned perfectly well for years with liabilities that exceeded their assets.
Some economists argue that negative net worth is damaging for other reasons. It undermines a central bank’s “institutional credibility”, even if it doesn’t impair its day-to-day viability. These economists worry that a broke central bank might compromise its independence by going cap in hand to the government, asking to be recapitalised. Or it might print currency willy nilly to cover its losses and earn its way out of its financial hole. Either response would damage its standing as the guardian of the nation’s money.
But these worries hardly apply to the SNB. It has suffered losses (now and in the past) because its currency has strengthened, a reflection of the confidence foreigners place in it. If anything, “institutional credibility” is a cause of its balance-sheet problem not a potential casualty of it. Right now, the Swiss National Bank’s ability to prevent inflation is not in doubt. What is in doubt is its ability to create it.
Besides, a central bank’s financial strength is not ultimately the source of its operational independence. If a society is not, on balance, committed to price stability, the central bank will struggle to achieve it, no matter how strong its balance sheet. By the same token, if inflation is sufficiently unpopular, the state will give its central bank the leeway it needs to prevent it. That remains the case even if the central bank needs recapitalising once in a while.
Misconception 3: The cap was protectionist
When the SNB imposed the cap back in September 2011, the Swiss franc was strengthening fast, bid up by “refugee-capital” seeking a safe haven from the eurozone’s troubles. The strong franc made Switzerland’s upscale goods even pricier abroad, damaging its exporters’ competitiveness.
The cap put a stop to that. It thus drew criticism from economists worried about the impact on Switzerland’s trading partners. Ted Truman of the Peterson Institute for International Economics has described the cap as “openly protectionist”. According to other commentators, the cap contributed to the “currency wars”, in which countries try to seize market share from each other by weakening their exchange rates. By removing the cap, Switzerland was acting like a “good world citizen”, according to Dean Baker of the Center for Economic Policy Research, giving an “economic boost” to other countries that will enjoy healthier trade balances as a result.
When the SNB introduced the cap, it was indeed concerned about the “massive overvaluation” of the Swiss franc. Safe-haven flows were driving up the currency, displacing its manufacturers, just as oil or gas earnings can hollow out a country’s industrial base. The Swiss cap was helpful in preventing Dutch disease.
But the central bank’s main motivation for imposing the cap was not protectionism. It was trying instead to avert the risk of deflation. In keeping the currency down, it was trying to drive prices up. This ambition to raise prices is at odds with the notion that it was seeking to protect Swiss exporters. Because in raising inflation, the SNB would have reduced Switzerland’s competitiveness (all else equal) not sharpened it. If an exporter’s local prices and wages go up, it becomes less competitive abroad, even if the exchange rate remains the same.
Currencies, it is fair to point out, move much faster than goods prices or wages. So although inflation would have eroded the competitiveness of Swiss exporters eventually, it would have taken time. Currency appreciation, on the other hand, worked with brutal speed.
In seeking gradual inflation rather than abrupt currency appreciation, the SNB was therefore helping the country’s exporters. But in doing so, it was not defying fundamental market forces. It was instead choosing to expose exporters to one set of market forces rather than another: the sluggish forces of the goods market, rather than the bone-shaking forces of the foreign-exchange market. Neither market is perfect. The goods market is bogged down by inertia, transaction costs and long-term contracts that inhibit price flexibility. The currency markets, on the other hand, are swayed by bouts of speculation and skittishness. Neither does an unimpeachable job of setting an economy’s terms of exchange with the rest of the world.
In practice, there is an easy way to tell the difference between the SNB’s policy and that of the “currency warriors”, mercantilist central banks that suppress their exchange rates for competitive gain. Like the SNB, the currency warriors buy dollars or euros to keep their currencies cheap. In so doing, they create additional local money, just as the SNB did. But unlike the SNB, they “sterilise” their interventions, withdrawing this extra money from circulation (either by selling other assets or raising reserve requirements on banks). This prevents prices from rising, thus preserving the competitive advantage their cheap currency provides.
The SNB was not waging this kind of warfare. In printing francs it was keeping its currency down but not its prices. If its policy had hurt its trading partners, they were free to retaliate by printing more money themselves. This tit-for-tat monetary easing would not have resulted in a zero-sum scramble for a fixed amount of global demand. It would instead have helped to increase world demand, in a process of mutually-assured reflation.
The Swiss policy was not, then, protectionist in intent, nor was it unsustainble. It exposed the Swiss National Bank to a loss of face, but not to a financial loss of any great economic consequence. I believe currency pegs remain a legitimate monetary choice—as long as central banks allow prices to adjust accordingly—if not always a wise one. I also think the removal of the Swiss cap was unnecessarily disruptive. The SNB must now find a new way to fend off deflation. And West Ham must find a new sponsor for its kit.
Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.
Source: http://www.economist.com/blogs/freeexchange/2015/01/switzerlands-monetary-policy
Wednesday, January 21, 2015
Out of favour Reits offer contrarian rate bet
This is a tough time for contrarians looking for bargains in the US equity market. Everyone is still enjoying the dance. Bad news does little or nothing to dent enthusiasm.
There is, however, at least one sector that has conspicuously failed to join in the party. Real estate investment trusts started to drop sharply back in May, and have not recovered. Virtually the entire sector suddenly went out of favour.
Using the FTSE-Nareit indices, US Reits are down 10.1 per cent since the beginning of May, even when yield is included, while the iShares Mortgage Real Estate exchange-traded fund, which tracks the Nareit index of mortgage Reits, has fallen 19.8 per cent. Meanwhile, the S&P 500 has gained 15.4 per cent.
There is an obvious reason for this. Reits are an interest rate play. Reits rely on debt markets to finance their attempts at growth, making them rate-sensitive.
They are required to pay out at least 90 per cent of their taxable income in dividends each year to maintain their status. With short-term interest rates held close to zero by the Federal Reserve, this made Reits very attractive – especially as they can now easily be bought through exchange traded funds.
Once the Fed started talking about “tapering” its monthly bond purchases, it was no surprise that bond yields rose and Reit shares fell.
The response to the Fed’s decision not to taper in September, however, has been surprising. Stocks have set new highs, but 10-year bond yields are still a full percentage point above where they were when taper talk started in May. Other instruments popular for their high income, such as utility stocks, high-yield bonds and master limited partnerships holding oil pipelines, have recovered significantly. Yet Reits are bumping along, barely above their lows for the year.
Reit opportunity?
Could this have created a Reit buying opportunity? There are two ways this might happen. First, the market may be wrong about interest rates. The consensus expectation is that tapering will happen fairly early next year, probably in March. While not great for Reits, the sell-off so far should have taken much of this risk into account.
If this does not happen, or if incoming Fed chair Janet Yellen succeeds in jawboning bond yields downward with strong forward guidance, then securities that offer an income will be popular again. That points particularly to Reits which hold mortgage-backed bonds – which have recently fallen far out of favour. A recent brutal sell-off hit Reits such as Annaly (now at its lowest level in more than a decade) and American Capital (at a four-year low), which hold bonds issued by the federal mortgage agencies and fund themselves largely through the repo market. When rates are rising, leveraged plays on mortgage-backed bonds are naturally unpopular, so these could be value traps.
What are the chances the market is wrong about rates? Under Mr Bernanke, the Fed tried to persuade traders that tapering was not the same as tightening monetary policy, and failed. Ms Yellen is geared to make another attempt; staff at the central bank have had an extra year to make their case, and this time they may succeed.
Also, the US economy might fail to continue its recovery, causing rates to fall.
Look for value
A second way for Reits to offer value lies in the way investors bought them during the upturn. The average Reit buyer would have been unlikely to have taken notice of any statistic other than yield, and buying through ETFs – almost by definition indiscriminate – has dominated the sector.
So, anyone with a grasp of how to value a Reit should be able to find bargains. Look for value, and for Reits whose line of business gives them a chance of strengthening in line with the market – even if rates rise and the economy recovers.
As a whole, US equity Reits trade at a discount of 6.8 per cent to net asset value, according to SNL Financial. But some are at a far deeper discount, with multifamily rental Reits selling for 18 per cent less than their net asset value.
Is this as tasty as it looks? Jason Lail, manager of property research for SNL Financial, suggests this sector could offer protection if rates rise as expected. Demand to rent apartments might rise if mortgage rates rise, putting ownership out of reach for many. And if the economy is strengthening, the army of twentysomethings now living with their parents might have enough money to rent.
Another sector that should benefit from an economic rebound is hotels (whose “leases” are renewed every night, and which trade at slightly below their net asset value).
Any move into Reits is a bet that the market is wrong about rates. But for anyone who thinks US rates will fall or stagnate next year, Reits repay close study. After an almost uniform rise in the US market, they appear to be the most attractively priced way to make that bet.
Source: http://www.ft.com/intl/cms/s/0/9520ba6a-56b7-11e3-8cca-00144feabdc0.html#axzz3PTZUNDox
There is, however, at least one sector that has conspicuously failed to join in the party. Real estate investment trusts started to drop sharply back in May, and have not recovered. Virtually the entire sector suddenly went out of favour.
Using the FTSE-Nareit indices, US Reits are down 10.1 per cent since the beginning of May, even when yield is included, while the iShares Mortgage Real Estate exchange-traded fund, which tracks the Nareit index of mortgage Reits, has fallen 19.8 per cent. Meanwhile, the S&P 500 has gained 15.4 per cent.
There is an obvious reason for this. Reits are an interest rate play. Reits rely on debt markets to finance their attempts at growth, making them rate-sensitive.
They are required to pay out at least 90 per cent of their taxable income in dividends each year to maintain their status. With short-term interest rates held close to zero by the Federal Reserve, this made Reits very attractive – especially as they can now easily be bought through exchange traded funds.
Once the Fed started talking about “tapering” its monthly bond purchases, it was no surprise that bond yields rose and Reit shares fell.
The response to the Fed’s decision not to taper in September, however, has been surprising. Stocks have set new highs, but 10-year bond yields are still a full percentage point above where they were when taper talk started in May. Other instruments popular for their high income, such as utility stocks, high-yield bonds and master limited partnerships holding oil pipelines, have recovered significantly. Yet Reits are bumping along, barely above their lows for the year.
Reit opportunity?
Could this have created a Reit buying opportunity? There are two ways this might happen. First, the market may be wrong about interest rates. The consensus expectation is that tapering will happen fairly early next year, probably in March. While not great for Reits, the sell-off so far should have taken much of this risk into account.
If this does not happen, or if incoming Fed chair Janet Yellen succeeds in jawboning bond yields downward with strong forward guidance, then securities that offer an income will be popular again. That points particularly to Reits which hold mortgage-backed bonds – which have recently fallen far out of favour. A recent brutal sell-off hit Reits such as Annaly (now at its lowest level in more than a decade) and American Capital (at a four-year low), which hold bonds issued by the federal mortgage agencies and fund themselves largely through the repo market. When rates are rising, leveraged plays on mortgage-backed bonds are naturally unpopular, so these could be value traps.
What are the chances the market is wrong about rates? Under Mr Bernanke, the Fed tried to persuade traders that tapering was not the same as tightening monetary policy, and failed. Ms Yellen is geared to make another attempt; staff at the central bank have had an extra year to make their case, and this time they may succeed.
Also, the US economy might fail to continue its recovery, causing rates to fall.
Look for value
A second way for Reits to offer value lies in the way investors bought them during the upturn. The average Reit buyer would have been unlikely to have taken notice of any statistic other than yield, and buying through ETFs – almost by definition indiscriminate – has dominated the sector.
So, anyone with a grasp of how to value a Reit should be able to find bargains. Look for value, and for Reits whose line of business gives them a chance of strengthening in line with the market – even if rates rise and the economy recovers.
As a whole, US equity Reits trade at a discount of 6.8 per cent to net asset value, according to SNL Financial. But some are at a far deeper discount, with multifamily rental Reits selling for 18 per cent less than their net asset value.
Is this as tasty as it looks? Jason Lail, manager of property research for SNL Financial, suggests this sector could offer protection if rates rise as expected. Demand to rent apartments might rise if mortgage rates rise, putting ownership out of reach for many. And if the economy is strengthening, the army of twentysomethings now living with their parents might have enough money to rent.
Another sector that should benefit from an economic rebound is hotels (whose “leases” are renewed every night, and which trade at slightly below their net asset value).
Any move into Reits is a bet that the market is wrong about rates. But for anyone who thinks US rates will fall or stagnate next year, Reits repay close study. After an almost uniform rise in the US market, they appear to be the most attractively priced way to make that bet.
Source: http://www.ft.com/intl/cms/s/0/9520ba6a-56b7-11e3-8cca-00144feabdc0.html#axzz3PTZUNDox
Tuesday, January 20, 2015
China’s Stimulus Quagmire
Even with Monday’s 7.6% decline, China’s stock market is on a historic tear, having risen more than 50% over the past year. Yet much of this investor frenzy is based on three flawed premises: that China’s decelerating growth necessitates stimulus, that such stimulus will reduce borrowing costs for firms, and that lower borrowing costs will incentivize spending and ultimately jumpstart growth.
New data from my firm’s China Beige Book—the largest private study of China’s economy—belie each of those assumptions. Our data make it clear that China doesn’t desperately need to stimulate its economy, that its recent attempts to lower interest rates via stimulus have done the opposite, and that if Beijing opts for large-scale stimulus anyway, it won’t work as intended.
Market participants often seem to misunderstand what China’s slowdown means. While the economy has continued to decelerate broadly, important components—including profit performance and the labor market—have shown overall improvement since 2014’s second-quarter nadir. In the just-completed fourth quarter, China Beige Book data on sales, profits and job growth all looked a bit better, as they had in the third quarter. This is a tentative rebound, to be sure, but it is hardly the gloom and doom narrative that most commentators (glued to older data) have now accepted as gospel.
Recent “stimulus” measures, including November’s cut to the benchmark lending rate, haven’t reduced borrowing costs for firms. The opposite has happened. Since last year’s second quarter, according to our data, the cost of capital has risen across the board—for bank loans, shadow-bank loans and especially bonds.
Perhaps most frequently overlooked: Firms still don’t want to borrow. The share of firms applying for and receiving loans dropped again in the fourth quarter, to the lowest levels we have recorded since beginning to survey in the first quarter of 2012. Since then, the share of firms borrowing has now dropped by more than half.
Crucially, firms don’t want to spend either. In the fourth quarter, growth in capital expenditure ticked down for the fourth straight quarter, also notching our survey’s all-time low.
Even the fourth quarter’s best performers—services firms—are caught in the wave: In multiple regions this quarter, including those that house the critical cities of Shanghai, Guangdong and Chongqing, services firms saw improved revenue growth, yet the proportion that hiked capital expenditures dropped anyway, in some cases dramatically. If firms don’t want to spend, monetary stimulus is a lost cause.
Plummeting crude-oil prices are a reason for optimism, given that China is a huge net consumer of energy. Our data track a steady pattern of disinflation in the Chinese economy since the first quarter of 2013, with sales prices, wages and material-input costs all continuing to rise, but ever more slowly. With the impact of cheap oil yet to be felt, 2014’s disinflation could become outright deflation in 2015.
Producer deflation is much better for an economy than consumer deflation. But with the economy slowing, Japan undertaking record quantitative easing and the eurozone headed in that direction, any sort of deflationary headwind may make it awfully hard for Beijing to resist another large stimulus of its own.
Here we get to the critical takeaways for investors: China’s slowdown may create the illusion that China has little choice but to stimulate, but our data show otherwise. Yet even if such stimulus is ultimately enacted, it simply will not work as intended.
Firms haven’t been interested in borrowing or spending on new projects for a year now. It is possible that low enough interest rates could change their behavior but to date rates haven’t been pushed downward by easing measures.
Instead, what companies are most likely to do if more liquidity is injected into the system is jump deeper into the roaring stock market. Already some of the inflows into stocks have come from the floundering property sector that Beijing has tried to stabilize.
If more firms move capital into stocks, the result won’t be more growth but rather more out-of-control prices for equities. And the structural impediments that are slowing China down will remain untouched.
Source: http://www.wsj.com/articles/leland-r-miller-chinas-stimulus-quagmire-1421688876
New data from my firm’s China Beige Book—the largest private study of China’s economy—belie each of those assumptions. Our data make it clear that China doesn’t desperately need to stimulate its economy, that its recent attempts to lower interest rates via stimulus have done the opposite, and that if Beijing opts for large-scale stimulus anyway, it won’t work as intended.
Market participants often seem to misunderstand what China’s slowdown means. While the economy has continued to decelerate broadly, important components—including profit performance and the labor market—have shown overall improvement since 2014’s second-quarter nadir. In the just-completed fourth quarter, China Beige Book data on sales, profits and job growth all looked a bit better, as they had in the third quarter. This is a tentative rebound, to be sure, but it is hardly the gloom and doom narrative that most commentators (glued to older data) have now accepted as gospel.
Recent “stimulus” measures, including November’s cut to the benchmark lending rate, haven’t reduced borrowing costs for firms. The opposite has happened. Since last year’s second quarter, according to our data, the cost of capital has risen across the board—for bank loans, shadow-bank loans and especially bonds.
Perhaps most frequently overlooked: Firms still don’t want to borrow. The share of firms applying for and receiving loans dropped again in the fourth quarter, to the lowest levels we have recorded since beginning to survey in the first quarter of 2012. Since then, the share of firms borrowing has now dropped by more than half.
Crucially, firms don’t want to spend either. In the fourth quarter, growth in capital expenditure ticked down for the fourth straight quarter, also notching our survey’s all-time low.
Even the fourth quarter’s best performers—services firms—are caught in the wave: In multiple regions this quarter, including those that house the critical cities of Shanghai, Guangdong and Chongqing, services firms saw improved revenue growth, yet the proportion that hiked capital expenditures dropped anyway, in some cases dramatically. If firms don’t want to spend, monetary stimulus is a lost cause.
Plummeting crude-oil prices are a reason for optimism, given that China is a huge net consumer of energy. Our data track a steady pattern of disinflation in the Chinese economy since the first quarter of 2013, with sales prices, wages and material-input costs all continuing to rise, but ever more slowly. With the impact of cheap oil yet to be felt, 2014’s disinflation could become outright deflation in 2015.
Producer deflation is much better for an economy than consumer deflation. But with the economy slowing, Japan undertaking record quantitative easing and the eurozone headed in that direction, any sort of deflationary headwind may make it awfully hard for Beijing to resist another large stimulus of its own.
Here we get to the critical takeaways for investors: China’s slowdown may create the illusion that China has little choice but to stimulate, but our data show otherwise. Yet even if such stimulus is ultimately enacted, it simply will not work as intended.
Firms haven’t been interested in borrowing or spending on new projects for a year now. It is possible that low enough interest rates could change their behavior but to date rates haven’t been pushed downward by easing measures.
Instead, what companies are most likely to do if more liquidity is injected into the system is jump deeper into the roaring stock market. Already some of the inflows into stocks have come from the floundering property sector that Beijing has tried to stabilize.
If more firms move capital into stocks, the result won’t be more growth but rather more out-of-control prices for equities. And the structural impediments that are slowing China down will remain untouched.
Source: http://www.wsj.com/articles/leland-r-miller-chinas-stimulus-quagmire-1421688876
Wednesday, December 31, 2014
Chinese insurer emulates ‘Buffett model’ with Waldorf purchase
The
previously obscure Chinese insurance company whose global shopping
spree has raised eyebrows in the investment world is pursuing a Warren
Buffett-like strategy in which investment returns drive growth and
insurance plays only a minor role.
Yet a look at Anbang’s business model suggests the company is more
like a private equity fund with a side business in insurance. Rather
than profiting from the excess of premiums over claims, analysts say
Anbang aims to generate earnings through investment returns.
Chinese entrepreneurs have expressed admiration for the “Warren Buffett model” in which insurance premiums provide cheap funding for far-flung equity investments.
In China, however, the strategy of using insurance as a platform for
unrelated investments is riskier, since the core insurance business is
less profitable than in the west.
Roughly 70 per cent of “life assurance” products in China are more akin to certificates of deposit. The customer pays a premium only once, and the insurer guarantees the return of principal plus interest after five to 15 years.
Insurers earn razor-thin margins on such products, which are sold mainly through banks and must compete for funds with lenders’ own high-yielding wealth management products.
Protection-type products, which only pay out in the event of an accident, illness or untimely death, deliver higher margins because the insurer doesn’t pay out on every policy, but still comprise only a small fraction of China’s overall insurance market.
Privately held Anbang collected Rmb33bn ($5.4bn) in life assurance premiums in the first eight months of 2014 versus only Rmb3.4bn in property and casualty fees, government data show.
Its profitability has been further compromised by its rapid growth strategy. Premiums have grown from Rmb1bn in 2005, the year after Anbang’s founding, to Rmb36bn so far this year. That has required big spending on hiring sales agents and paying commissions to banks that champion their policies.
“I can’t see how they’re making a profit, with all the reserves they have to put away and all the acquisition costs. I would be stunned,” says Sam Radwan, co-founder of Enhance, a management consultancy that advises China’s insurance industry.
Premiums at Anbang’s life assurance unit amounted to only 8 per cent of assets by end the of 2013, compared to 16 per cent at China Life. That suggests Anbang is using equity capital, rather than premiums, to finance its purchases.
China Life and Ping An have both ventured into foreign real estate over the past year, following regulations enacted in 2012 permitting such investments by insurers. But their core businesses are more diverse and profitable than Anbang, meaning investment returns are icing on the insurance cake.
Anbang raised its registered capital to Rmb30bn in April this year,
up from Rmb12bn in 2011 and more than the Rmb28bn in registered capital
at rival China Life.
If it succeeds in efforts to emulate Mr Buffett, the danger is that
Anbang ends up resigning itself to unprofitability in its core business
and basing its strategy solely on high-risk investments.
“If you’re playing the asset game and pushing your yield, you can get yourself into a lot of trouble,” says Mr Radwan.
Source: http://www.ft.com/intl/cms/s/0/9b6f1036-5424-11e4-80db-00144feab7de.html
This month alone, Beijing-based Anbang Insurance Group announced the purchase of Manhattan’s Waldorf Astoria
hotel for $1.95bn and Belgian insurer Fidea for an undisclosed price.
South Korean media have also reported that Anbang is considering
acquiring a controlling stake in state-run Woori Bank.
Such
ambitious investment may seem strange for a company that ranks eighth
among Chinese life assurers with only a 3.6 per cent market share, far
below leaders China Life and Ping An, which control 25 and 14 per cent, respectively.
Chinese entrepreneurs have expressed admiration for the “Warren Buffett model” in which insurance premiums provide cheap funding for far-flung equity investments.
Fosun founder Guo Guangchang has frequently cited the example of Mr Buffett in outlining intentions to transform his industrial conglomerate into a strategic investment group.
Roughly 70 per cent of “life assurance” products in China are more akin to certificates of deposit. The customer pays a premium only once, and the insurer guarantees the return of principal plus interest after five to 15 years.
Insurers earn razor-thin margins on such products, which are sold mainly through banks and must compete for funds with lenders’ own high-yielding wealth management products.
Protection-type products, which only pay out in the event of an accident, illness or untimely death, deliver higher margins because the insurer doesn’t pay out on every policy, but still comprise only a small fraction of China’s overall insurance market.
Privately held Anbang collected Rmb33bn ($5.4bn) in life assurance premiums in the first eight months of 2014 versus only Rmb3.4bn in property and casualty fees, government data show.
Its profitability has been further compromised by its rapid growth strategy. Premiums have grown from Rmb1bn in 2005, the year after Anbang’s founding, to Rmb36bn so far this year. That has required big spending on hiring sales agents and paying commissions to banks that champion their policies.
“I can’t see how they’re making a profit, with all the reserves they have to put away and all the acquisition costs. I would be stunned,” says Sam Radwan, co-founder of Enhance, a management consultancy that advises China’s insurance industry.
Premiums at Anbang’s life assurance unit amounted to only 8 per cent of assets by end the of 2013, compared to 16 per cent at China Life. That suggests Anbang is using equity capital, rather than premiums, to finance its purchases.
China Life and Ping An have both ventured into foreign real estate over the past year, following regulations enacted in 2012 permitting such investments by insurers. But their core businesses are more diverse and profitable than Anbang, meaning investment returns are icing on the insurance cake.
Still, in other respects Anbang seems well-suited to the Buffett model given the proven ability of founder and chairman Wu Xiaohui, son-in-law of late paramount leader Deng Xiaoping, to raise funds from China’s elite state-owned companies.
A complete shareholder list is not publicly available, but the company has wooed investors including state-owned oil refiner Sinopec and SAIC Motor, China’s largest carmaker, according to state media. Anbang could not be reached for comment.
“If you’re playing the asset game and pushing your yield, you can get yourself into a lot of trouble,” says Mr Radwan.
Source: http://www.ft.com/intl/cms/s/0/9b6f1036-5424-11e4-80db-00144feab7de.html
Friday, December 26, 2014
Ecommerce model proves difficult to drive
As British comedian Eddie Izzard once observed — if not in those
exact words — the concept of landline telephony must sound ridiculous to
the youth of today.
But, as many households will have discovered over the holiday season, the 21st century concept of ecommerce is barely any more intelligent. While it may be increasingly app driven on mobile devices, it still involves goods being driven in delivery vans — in the vague hope that, in an unknowable number of days, they will arrive at a building at the very moment when one may be found therein.
Even some of the solutions to these challenges appear daft. Earlier this year, Volvo, the carmaker, announced an initiative to avoid the “first-time delivery failures” that cost companies “an estimated €1bn”: it will arrange for an operative to drive to where one’s Volvo is parked and place purchased goods therein. Anywhere. Even a shopping centre car park.
However, with a global value of €172bn — according to the dubiously named Transport Intelligence — ecommerce delivery is not a business that investors can ignore.
It offers revenue growth: analysts at Transport Intelligence forecast a rate of 9.8 per cent a year until 2017. It offers cash flows: Ofcom estimates that Britons pump £1,968 per person through ecommerce channels every year, followed by US consumers who spend £1,171 each. It offers more predictability: research group ComScore says online sales growth on Cyber Monday, after Thanksgiving, has slowed because consumers now spread out their purchases.
Far from proving the telecoms-like income plays that their activities
suggest, all these companies’ shares look low yield and expensive.
FedEx offers a dividend yield of 0.5 per cent, and trades on 19.7 2015
earnings — well ahead of the S&P 500. UPS shares yield 2.39 per cent
but trade on 19.9 times forward earnings. Not exactly a utility.
Royal Mail currently yields more than 4 per cent but also trades on an earnings multiple closer to higher margin FTSE 100 companies.
Where, then, is the value? Ironically, some of the most attractive yields in ecommerce now come from bricks and mortar. According to IPD, the European warehouses from whence all those vans set off yielded 8 per cent in the 12 months to end September. As one fund manager told the Financial Times last week: “It’s a very defensive asset class to invest in.” He believes ecommerce property is not just for Christmas — rather like those missing parcels you might receive in coming days.
Source: http://www.ft.com/intl/cms/s/0/9718e448-8b7a-11e4-be89-00144feabdc0.html
But, as many households will have discovered over the holiday season, the 21st century concept of ecommerce is barely any more intelligent. While it may be increasingly app driven on mobile devices, it still involves goods being driven in delivery vans — in the vague hope that, in an unknowable number of days, they will arrive at a building at the very moment when one may be found therein.
Even some of the solutions to these challenges appear daft. Earlier this year, Volvo, the carmaker, announced an initiative to avoid the “first-time delivery failures” that cost companies “an estimated €1bn”: it will arrange for an operative to drive to where one’s Volvo is parked and place purchased goods therein. Anywhere. Even a shopping centre car park.
However, with a global value of €172bn — according to the dubiously named Transport Intelligence — ecommerce delivery is not a business that investors can ignore.
It offers revenue growth: analysts at Transport Intelligence forecast a rate of 9.8 per cent a year until 2017. It offers cash flows: Ofcom estimates that Britons pump £1,968 per person through ecommerce channels every year, followed by US consumers who spend £1,171 each. It offers more predictability: research group ComScore says online sales growth on Cyber Monday, after Thanksgiving, has slowed because consumers now spread out their purchases.
Delivery companies, though, seem stuck at the wrong end of the value chain. In the UK, private equity-owned delivery business City Link went
into administration on Christmas Eve, claiming it was unable to handle
any more parcels because of the “continued substantial losses it would
incur”. Earlier this year, the privatised Royal Mail
reported a 21 per cent drop in first-half operating profits, from £353m
to £279m, in the face of greater competition. In the same period, UK Mail’s margins were such that it made just £4.9m of pre-tax profit on revenues of £241.4m.
In the US, FedEx and UPS
have at times found the ecommerce model more costly than lucrative. UPS
warned on profit in early 2014 after a failure to deliver thousands of
parcels cut quarterly earnings by 14 per cent.
Royal Mail currently yields more than 4 per cent but also trades on an earnings multiple closer to higher margin FTSE 100 companies.
Where, then, is the value? Ironically, some of the most attractive yields in ecommerce now come from bricks and mortar. According to IPD, the European warehouses from whence all those vans set off yielded 8 per cent in the 12 months to end September. As one fund manager told the Financial Times last week: “It’s a very defensive asset class to invest in.” He believes ecommerce property is not just for Christmas — rather like those missing parcels you might receive in coming days.
Source: http://www.ft.com/intl/cms/s/0/9718e448-8b7a-11e4-be89-00144feabdc0.html
Monday, September 29, 2014
The 2014 M&A Report
If
one had to choose a single word to describe the M&A market in 2013,
it would be disappointing, and indeed many market participants have
used this very term. But the exasperated dealmakers have had little time
to cry in their beer—they’ve been too busy. The M&A market took off
like a rocket in 2014, fueled by the return of the megadeal
(transactions with a value of more than $10 billion), which has been in
hibernation for the last several years. The momentum of the first
quarter carried into the second, setting up 2014 as a potential
bellwether for the market’s longer-term evolution.
Megadeals capture the headlines, adding confidence to the market. At the same time, there is another, less publicized but no less significant, trend developing—one that should attract even greater interest in the boardroom. As we first noted two years ago, our research shows a continuing rise in divestitures as a powerful strategy for both unlocking value in today’s markets and improving performance by focusing on core operations. (See Plant and Prune: How M&A Can Grow Portfolio Value (https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_plant_and_prune_m_and_a_2012/), BCG report, September 2012.) In 2013, divestitures represented almost half the total M&A market. Not all divestitures are created equal or produce equivalent results, however. The companion to this year’s M&A report—the tenth in our series highlighting major trends and their implications for companies—examines in depth the role of an active divestiture strategy in companies’ ongoing search for value.
Will the Pace Pick Up?
Multiple factors—principal among them large cash reserves, bullish investors, and buoyant debt markets—point to a continued resurgence in deal activity.
Corporate cash reserves have been increasing since the financial crisis. Countless companies have used the downturn to strengthen their balance sheets and improve their performance, giving them a much-enhanced means of financing acquisitions. Corporate cash levels are at an all-time high—three times their level in 2000. Shareholders become restless with so much money sitting idly on the sidelines, and they will eventually demand that companies either put the money to work or distribute it to their owners through share buybacks or dividends, especially as the uncertainty in capital markets recedes. As economic conditions improve, investors are becoming far more receptive to companies making acquisitions so long as the deals are consistent with their strategy and, of course, the price is seen as reasonable. In BCG’s 2014 investor survey, the percentage of respondents favoring a more aggressive approach to M&A by companies almost tripled, from 23 percent to 60 percent, between 2012 and 2014. (See Exhibit 4.)
While activity among private-equity players has increased only slightly so far—the number of transactions rose 22 percent between 2012 and 2013, but the total value actually declined 3 percent—we do not see these firms remaining quiet for long. At a total of $431 billion, private-equity cash reserves are approaching their levels in 2008 and 2009, and these firms have their own investors to answer to. Moreover, debt financing is more readily available now than at any time in recent years. Leverage levels have returned to those of 2007 and 2008. (See Exhibit 5.) The average deal in 2013 included only 35 percent equity. “Covenant lite” loan activity in 2013 also smashed all records. The incidence of these loans, which generally do not involve any maintenance covenants, indicates growing investor appetite in the leveraged-loan market, making borrowing even more attractive for private-equity deals. We expect private-equity firms to become much more active in all kinds of transactions, with the exception of the largest megadeals, which are simply beyond their reach, if not their comfort zone.
Last but hardly far from least, current transaction valuations are still within long-term historical parameters. Valuation levels (as measured by the ratio of median acquisition enterprise value to EBITDA—EV/EBITDA) have been generally (if unevenly) rising since 2008, and they surpassed the historical average of 11.9 in the first half of 2014. Deal premiums (the amount by which the offer price exceeds the target company’s closing stock price one week before the original announcement date) approximated their historical average of 35.4 percent in 2013. One could thus argue that targets are not yet overvalued from a historical perspective—one more reason why deal activity among both corporate and private-equity players should continue to increase.
That said, it should also be noted that some industries are distinctly more active than others. Our analysis of deal volume (measured by transaction value) shows clear sector differences when long-term historical activity (from 1990 through 2010) is compared with deals done since 2011.
Energy, for example, saw a 4-percentage-point uptick in the current period, owing primarily to portfolio restructurings and consolidation, as well as to an increased focus on renewable energies following the Fukushima accident. Higher levels of activity in the health care sector (up 3 percentage points) are substantially the result of pharmaceutical companies acquiring new research pipelines as their own R&D programs produce fewer blockbusters and the patents covering older top-selling drugs expire. Changes in health care regulations in the U.S. and a difficult environment in Europe are also fueling consolidation in the sector. Companies in the industrial sector have been optimizing their portfolios as economies stabilize and return to growth. And, of course, high tech is highly active.
There is a clear impact of M&A intensity in “hot” industries: target companies are able to demand higher premiums from potential buyers. (See Exhibit 6.) Companies acquired in high tech and health care, for example, received average premiums of 36.5 percent and 37.3 percent, respectively, compared with premiums of only 29.9 percent in consumer and retail and 33.0 percent in financial services and real estate.
Timing is not everything in M&A, but it almost always is a critical factor and certainly an important consideration for both buyers and sellers during upswings in their industries.
Source: https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_2014_m_a_report/
Megadeals capture the headlines, adding confidence to the market. At the same time, there is another, less publicized but no less significant, trend developing—one that should attract even greater interest in the boardroom. As we first noted two years ago, our research shows a continuing rise in divestitures as a powerful strategy for both unlocking value in today’s markets and improving performance by focusing on core operations. (See Plant and Prune: How M&A Can Grow Portfolio Value (https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_plant_and_prune_m_and_a_2012/), BCG report, September 2012.) In 2013, divestitures represented almost half the total M&A market. Not all divestitures are created equal or produce equivalent results, however. The companion to this year’s M&A report—the tenth in our series highlighting major trends and their implications for companies—examines in depth the role of an active divestiture strategy in companies’ ongoing search for value.
2013: Hopes Unrealized; 2014: Hopes Heightened
Is the long post-2008 M&A hangover finally coming to an end?
Positive signs abound, for a change, starting with strong market
activity. The Boston Consulting Group’s tenth annual assessment of
crucial M&A trends, based on BCG’s global M&A database of almost
40,000 transactions since 1990, shows that following an anemic 2011 and
a slow 2012, the M&A market stabilized in 2013, albeit at
disappointing levels. It entered 2014 with a strong tailwind, including
the announcement of roughly as many megadeals in the first six months as
in the two previous years combined.
Multiple factors are fueling the resurgence. Continued low interest rates, the ample availability of capital, a less uncertain economic outlook, and high levels of M&A interest and financial capability on the part of both corporations and private-equity firms all bode well for the future. In addition, continuing a trend begun a few years ago, corporate divestitures are taking a growing share of the overall M&A market. (See Creating Shareholder Value with Divestitures (https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_creating_shareholder_value_divestitures/), BCG article, September 2014.)
After furrowing a deep trough in the years following 2008, the M&A market has at last recovered to the levels of 2005 and 2006. That said, most market participants saw 2013 as a disappointment. Overall deal volume declined by 6 percent and total deal value fell by 10 percent from 2012—despite credit remaining cheap, corporate profits continuing to rise, and generally strong performance by global equity markets. (See Exhibit 1.)
Multiple culprits can be identified. Most significantly, the much-awaited economic recovery failed to materialize, and neither employment levels nor consumer confidence improved as expected. GDP growth disappointed just about everywhere, especially in Europe, and many companies also held back from pursuing big or aggressive transactions owing to the continuing economic uncertainty. Deal volume and value fell in the financial-services and metals-and-mining sectors after heightened activity in the preceding years. Activity in Japan and a number of emerging markets, especially Brazil, Russia, and India, also declined. As is the case every year, several hundred transactions were announced but failed to reach consummation. The number of uncompleted deals was roughly equal in 2013 and 2012, but the total value of the withdrawn deals in 2013 was bigger as several large transactions were canceled, including the acquisition of 70 percent of Koninklijke KPN by América Móvil for $10 billion and the sale of BlackBerry to Fairfax Financial Holdings for $5 billion.
How quickly sentiments—and outlook—can change, however. The total value of first-half 2014 transactions jumped 62 percent over the value of transactions in the first six months of 2013. Megadeals accounted for more than 35 percent of total first-half 2014 deal value, including five deals worth more than $43 billion each—a level of activity not witnessed since before the financial crisis. These types of transactions not only boost the statistics, they also transform the confidence level of the market. Dealmakers who have been sitting on the sidelines, uncertain about financing, investor reaction, regulatory approvals, or other factors, see industry-altering transactions in the works and start to believe their deals can get done. Indeed, the hot pace continued into the second quarter, with AT&T’s acquisition of Directv, Apple’s acquisition of Beats Electronics, the $50 billion merger of cement makers Lafarge and Holcim, and the heated competition to acquire Alstom’s energy-equipment assets, which General Electric appears poised to win.
The overall economic outlook is the most positive in years, with U.S. GDP growth projected to approach 3 percent as we move into 2015, and growth expected to return to Europe, albeit slowly. Equity markets are holding up thus far, through the end of the second quarter. As always, there are risks that political or international events—in the Middle East and Ukraine, for example—could have a negative impact on the economy and thus on deal activity.
Multiple factors are fueling the resurgence. Continued low interest rates, the ample availability of capital, a less uncertain economic outlook, and high levels of M&A interest and financial capability on the part of both corporations and private-equity firms all bode well for the future. In addition, continuing a trend begun a few years ago, corporate divestitures are taking a growing share of the overall M&A market. (See Creating Shareholder Value with Divestitures (https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_creating_shareholder_value_divestitures/), BCG article, September 2014.)
After furrowing a deep trough in the years following 2008, the M&A market has at last recovered to the levels of 2005 and 2006. That said, most market participants saw 2013 as a disappointment. Overall deal volume declined by 6 percent and total deal value fell by 10 percent from 2012—despite credit remaining cheap, corporate profits continuing to rise, and generally strong performance by global equity markets. (See Exhibit 1.)
Multiple culprits can be identified. Most significantly, the much-awaited economic recovery failed to materialize, and neither employment levels nor consumer confidence improved as expected. GDP growth disappointed just about everywhere, especially in Europe, and many companies also held back from pursuing big or aggressive transactions owing to the continuing economic uncertainty. Deal volume and value fell in the financial-services and metals-and-mining sectors after heightened activity in the preceding years. Activity in Japan and a number of emerging markets, especially Brazil, Russia, and India, also declined. As is the case every year, several hundred transactions were announced but failed to reach consummation. The number of uncompleted deals was roughly equal in 2013 and 2012, but the total value of the withdrawn deals in 2013 was bigger as several large transactions were canceled, including the acquisition of 70 percent of Koninklijke KPN by América Móvil for $10 billion and the sale of BlackBerry to Fairfax Financial Holdings for $5 billion.
How quickly sentiments—and outlook—can change, however. The total value of first-half 2014 transactions jumped 62 percent over the value of transactions in the first six months of 2013. Megadeals accounted for more than 35 percent of total first-half 2014 deal value, including five deals worth more than $43 billion each—a level of activity not witnessed since before the financial crisis. These types of transactions not only boost the statistics, they also transform the confidence level of the market. Dealmakers who have been sitting on the sidelines, uncertain about financing, investor reaction, regulatory approvals, or other factors, see industry-altering transactions in the works and start to believe their deals can get done. Indeed, the hot pace continued into the second quarter, with AT&T’s acquisition of Directv, Apple’s acquisition of Beats Electronics, the $50 billion merger of cement makers Lafarge and Holcim, and the heated competition to acquire Alstom’s energy-equipment assets, which General Electric appears poised to win.
The overall economic outlook is the most positive in years, with U.S. GDP growth projected to approach 3 percent as we move into 2015, and growth expected to return to Europe, albeit slowly. Equity markets are holding up thus far, through the end of the second quarter. As always, there are risks that political or international events—in the Middle East and Ukraine, for example—could have a negative impact on the economy and thus on deal activity.
North America Leads the Comeback—Fueled by High Tech
The global M&A market is led by North America, whose share
has been on the rise and reached 52 percent in the first half of 2014—up
from 45 percent in 2010. While M&A activity stagnated or even
decreased in most regions of the world, total deal value in the U.S. and
Canada rose more than 5 percent per year over this period. The roaring
tech sector has been a driving force, since the most prominent players
in high-tech M&A are based in the U.S. (See Exhibit 2.)
Rather than following an overarching industry trend, many tech deals are rooted in individual company needs—Apple’s acquisition of Beats to rejuvenate its music business, for example. With the acquisitions of Oculus VR and Nest Labs, respectively, Facebook and Google are looking to stay at the cutting edge of technological advances with strong consumer applications, as innovations such as augmented reality and machine-to-machine communications begin to gain market traction. Priceline.com’s purchase of online restaurant-reservation service OpenTable (for $2.7 billion) promises the potential of cross-marketing to different digital consumer segments.
The rapid rise of mobile as the world’s dominant communications technology is spurring M&A activity in several spheres. Facebook’s acquisition of WhatsApp and Verizon’s $130 billion acquisition of Vodafone’s interest in Verizon Wireless show companies expanding, or consolidating control of, their share of mobile users. Microsoft is gaining control over mobile technology with its acquisition of Nokia’s device-and-service business.
Not all the tech activity is in North America. Dozens of deals have been announced involving European countries in late 2013 and the first half of 2014. However, since many of them represent smaller transactions, their overall impact on M&A markets has been less visible.
Outside the tech sector, so-called inversion deals are becoming an increasingly significant factor, particularly in the health care industry. U.S. companies are seeking acquisitions in Europe that make strategic sense and enable the acquirer to move its corporate domicile to Europe, where the company will benefit from more favorable tax treatment. In July, the Wall Street Journal estimated that almost a dozen such deals were pending, with a total value exceeding $100 billion.
Despite a rising number of transactions, capital markets continue to have difficulty deciphering the new business models of innovative tech companies and coming to grips with the seemingly outsize valuations that acquirers place on their targets, which often have limited track records and little or no earnings history. Memories of the bursting dot-com bubble in 2000 are still fairly fresh.
The February 2014 announcement of Facebook’s plan to acquire WhatsApp, a five-year-old cross-platform instant-messaging service with 55 employees, for $19 billion in cash and stock is a case in point—especially since WhatsApp had only recently completed a round of venture-capital funding that valued the company at $1.5 billion. Immediately after Facebook announced the acquisition, its share price dropped 5 percent because of skepticism over the deal and the company’s rationale. It took several days—and a concerted investor-outreach effort—for investors to understand the basis for the deal, both strategic and financial. The market ultimately awarded Facebook a cumulative abnormal return (CAR) of 1.1 percent. (CAR assesses a deal’s impact by measuring the total abnormal change in market value over a seven-day window centered on the transaction announcement date.) The market came to recognize that with WhatsApp’s more than 450 million mobile users and rapid user growth, Facebook was acquiring a potentially formidable competitor and strengthening its own mobile position at the same time. Perhaps most significantly, the price it was paying for WhatsApp was equal to $42 per mobile user—several times less than the value the market was placing on each mobile user of Facebook itself ($141) or its fellow social network, Twitter ($124). (See Exhibit 3.)
Rather than following an overarching industry trend, many tech deals are rooted in individual company needs—Apple’s acquisition of Beats to rejuvenate its music business, for example. With the acquisitions of Oculus VR and Nest Labs, respectively, Facebook and Google are looking to stay at the cutting edge of technological advances with strong consumer applications, as innovations such as augmented reality and machine-to-machine communications begin to gain market traction. Priceline.com’s purchase of online restaurant-reservation service OpenTable (for $2.7 billion) promises the potential of cross-marketing to different digital consumer segments.
The rapid rise of mobile as the world’s dominant communications technology is spurring M&A activity in several spheres. Facebook’s acquisition of WhatsApp and Verizon’s $130 billion acquisition of Vodafone’s interest in Verizon Wireless show companies expanding, or consolidating control of, their share of mobile users. Microsoft is gaining control over mobile technology with its acquisition of Nokia’s device-and-service business.
Not all the tech activity is in North America. Dozens of deals have been announced involving European countries in late 2013 and the first half of 2014. However, since many of them represent smaller transactions, their overall impact on M&A markets has been less visible.
Outside the tech sector, so-called inversion deals are becoming an increasingly significant factor, particularly in the health care industry. U.S. companies are seeking acquisitions in Europe that make strategic sense and enable the acquirer to move its corporate domicile to Europe, where the company will benefit from more favorable tax treatment. In July, the Wall Street Journal estimated that almost a dozen such deals were pending, with a total value exceeding $100 billion.
Despite a rising number of transactions, capital markets continue to have difficulty deciphering the new business models of innovative tech companies and coming to grips with the seemingly outsize valuations that acquirers place on their targets, which often have limited track records and little or no earnings history. Memories of the bursting dot-com bubble in 2000 are still fairly fresh.
The February 2014 announcement of Facebook’s plan to acquire WhatsApp, a five-year-old cross-platform instant-messaging service with 55 employees, for $19 billion in cash and stock is a case in point—especially since WhatsApp had only recently completed a round of venture-capital funding that valued the company at $1.5 billion. Immediately after Facebook announced the acquisition, its share price dropped 5 percent because of skepticism over the deal and the company’s rationale. It took several days—and a concerted investor-outreach effort—for investors to understand the basis for the deal, both strategic and financial. The market ultimately awarded Facebook a cumulative abnormal return (CAR) of 1.1 percent. (CAR assesses a deal’s impact by measuring the total abnormal change in market value over a seven-day window centered on the transaction announcement date.) The market came to recognize that with WhatsApp’s more than 450 million mobile users and rapid user growth, Facebook was acquiring a potentially formidable competitor and strengthening its own mobile position at the same time. Perhaps most significantly, the price it was paying for WhatsApp was equal to $42 per mobile user—several times less than the value the market was placing on each mobile user of Facebook itself ($141) or its fellow social network, Twitter ($124). (See Exhibit 3.)
Will the Pace Pick Up?
Multiple factors—principal among them large cash reserves, bullish investors, and buoyant debt markets—point to a continued resurgence in deal activity.
Corporate cash reserves have been increasing since the financial crisis. Countless companies have used the downturn to strengthen their balance sheets and improve their performance, giving them a much-enhanced means of financing acquisitions. Corporate cash levels are at an all-time high—three times their level in 2000. Shareholders become restless with so much money sitting idly on the sidelines, and they will eventually demand that companies either put the money to work or distribute it to their owners through share buybacks or dividends, especially as the uncertainty in capital markets recedes. As economic conditions improve, investors are becoming far more receptive to companies making acquisitions so long as the deals are consistent with their strategy and, of course, the price is seen as reasonable. In BCG’s 2014 investor survey, the percentage of respondents favoring a more aggressive approach to M&A by companies almost tripled, from 23 percent to 60 percent, between 2012 and 2014. (See Exhibit 4.)
While activity among private-equity players has increased only slightly so far—the number of transactions rose 22 percent between 2012 and 2013, but the total value actually declined 3 percent—we do not see these firms remaining quiet for long. At a total of $431 billion, private-equity cash reserves are approaching their levels in 2008 and 2009, and these firms have their own investors to answer to. Moreover, debt financing is more readily available now than at any time in recent years. Leverage levels have returned to those of 2007 and 2008. (See Exhibit 5.) The average deal in 2013 included only 35 percent equity. “Covenant lite” loan activity in 2013 also smashed all records. The incidence of these loans, which generally do not involve any maintenance covenants, indicates growing investor appetite in the leveraged-loan market, making borrowing even more attractive for private-equity deals. We expect private-equity firms to become much more active in all kinds of transactions, with the exception of the largest megadeals, which are simply beyond their reach, if not their comfort zone.
Last but hardly far from least, current transaction valuations are still within long-term historical parameters. Valuation levels (as measured by the ratio of median acquisition enterprise value to EBITDA—EV/EBITDA) have been generally (if unevenly) rising since 2008, and they surpassed the historical average of 11.9 in the first half of 2014. Deal premiums (the amount by which the offer price exceeds the target company’s closing stock price one week before the original announcement date) approximated their historical average of 35.4 percent in 2013. One could thus argue that targets are not yet overvalued from a historical perspective—one more reason why deal activity among both corporate and private-equity players should continue to increase.
That said, it should also be noted that some industries are distinctly more active than others. Our analysis of deal volume (measured by transaction value) shows clear sector differences when long-term historical activity (from 1990 through 2010) is compared with deals done since 2011.
Energy, for example, saw a 4-percentage-point uptick in the current period, owing primarily to portfolio restructurings and consolidation, as well as to an increased focus on renewable energies following the Fukushima accident. Higher levels of activity in the health care sector (up 3 percentage points) are substantially the result of pharmaceutical companies acquiring new research pipelines as their own R&D programs produce fewer blockbusters and the patents covering older top-selling drugs expire. Changes in health care regulations in the U.S. and a difficult environment in Europe are also fueling consolidation in the sector. Companies in the industrial sector have been optimizing their portfolios as economies stabilize and return to growth. And, of course, high tech is highly active.
There is a clear impact of M&A intensity in “hot” industries: target companies are able to demand higher premiums from potential buyers. (See Exhibit 6.) Companies acquired in high tech and health care, for example, received average premiums of 36.5 percent and 37.3 percent, respectively, compared with premiums of only 29.9 percent in consumer and retail and 33.0 percent in financial services and real estate.
Timing is not everything in M&A, but it almost always is a critical factor and certainly an important consideration for both buyers and sellers during upswings in their industries.
Source: https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_2014_m_a_report/
Monday, August 18, 2014
Don’t fight the US Treasury bond rally
The consensus among market watchers last September was that, with US interest rates so low and the US Federal Reserve about to withdraw stimulus, interest rates would trend higher. I took a different view, writing in a commentary that “10-year rates may be heading back to 2.25 per cent or lower”.
When 10-year Treasury yields ended 2013 at 3.02 per cent, some may have thought I had taken the wrong end of the bet. But in early August, 10-year Treasury yields went as low as 2.35 per cent and I believe the path of least resistance on interest rates is still lower.
A number of factors have helped push Treasury yields lower. With yields on German 10-year bonds at historic lows of about 1 per cent and Japanese government bonds yielding around 50 basis points, Treasuries look comparatively attractive. Add to that the perception that both the yen and euro are a one-way bet towards depreciation and it is reasonable to expect that international capital will continue flowing towards the US, pressuring Treasury yields down as quantitative easing draws to an end.
Tensions from Ukraine to Iraq have added to a flight-to-quality trade, boosting demand for Treasuries. With the size of incremental US government borrowing also expected to decline because of shrinking federal budget deficits, Treasury yields could move lower.
Reduce rate risk
My original forecast of 2.0-2.25 per cent still seems reasonable. Nevertheless, markets do not move in straight lines, so yields could retrace to 2.5 per cent in the near term. Ultimately, as rates head back towards 2 per cent portfolio managers should use the rally to reduce interest rate risk.
As anyone experienced in investing in the US mortgage market knows there is a phenomenon that traders call the “refi bid”. When interest rates fall, a larger percentage of mortgages becomes economically attractive to refinance at a lower interest rate.
Whenever a threshold is breached where a large amount of mortgages make attractive refinancing candidates, prepayments spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.
Currently, I estimate that the next “refi level” will hit when the 10-year Treasury yield drops to about 2.25 per cent.
An unusual feature of this potential wave of mortgage refinancing is that the vast majority of US mortgages are on the cusp of being candidates for refinancing, given the relative stability of mortgage rates over the past year or so.
Additionally, there is one dominant holder of these mortgage securities that has vowed to reinvest in new mortgages as prepayments come in – the Fed.
Traditionally, in a refinancing rally, spreads on mortgage-backed securities widen due to increased prepayment risk and expected increases in supply. Spreads will not widen on this occasion to the same extent as during previous refi rallies for a number of technical reasons.
Among those reasons is that the Fed, the biggest mortgage investor on the block, has made clear it will reinvest principal repayments dollar for dollar. Normally, the widening in mortgage spreads mutes the impact of the rate decline on mortgage rates, slowing the pace of refinancing.
This time, advertised mortgage rates are likely to fall more rapidly than in prior refi experiences.
Selling opportunity
Given the likely rapidity of the interest rate decline, the potential for shortening in the duration of fixed income investment portfolios could further intensify the current rally and lead to a more extreme decline in rates than would normally be anticipated.
Declining mortgage rates will also give a lift to housing affordability, which could help clear unsold inventories of homes and support new construction activity. This would further support the US economy.
Ultimately, this expected run-up in bond prices and the associated decline in interest rates should prove unsustainable once the refinancing bid is past. For the near term, risks favour lower interest rates – perhaps sharply lower. In the medium term, as the economy strengthens further, this rally will reverse itself and will have proven to be a selling opportunity.
It is premature to sell now, but as 10-year Treasury yields approach 2 per cent it should provide an opportunity to rebalance portfolios. In other words, don’t chase the rally, but don’t fight it either. The opportunity to sell bonds is coming – but not just yet.
Source: http://www.ft.com/intl/cms/s/0/ece5bb60-22e0-11e4-9dc4-00144feabdc0.html#axzz3AkAuS7S0
When 10-year Treasury yields ended 2013 at 3.02 per cent, some may have thought I had taken the wrong end of the bet. But in early August, 10-year Treasury yields went as low as 2.35 per cent and I believe the path of least resistance on interest rates is still lower.
A number of factors have helped push Treasury yields lower. With yields on German 10-year bonds at historic lows of about 1 per cent and Japanese government bonds yielding around 50 basis points, Treasuries look comparatively attractive. Add to that the perception that both the yen and euro are a one-way bet towards depreciation and it is reasonable to expect that international capital will continue flowing towards the US, pressuring Treasury yields down as quantitative easing draws to an end.
Tensions from Ukraine to Iraq have added to a flight-to-quality trade, boosting demand for Treasuries. With the size of incremental US government borrowing also expected to decline because of shrinking federal budget deficits, Treasury yields could move lower.
Reduce rate risk
My original forecast of 2.0-2.25 per cent still seems reasonable. Nevertheless, markets do not move in straight lines, so yields could retrace to 2.5 per cent in the near term. Ultimately, as rates head back towards 2 per cent portfolio managers should use the rally to reduce interest rate risk.
As anyone experienced in investing in the US mortgage market knows there is a phenomenon that traders call the “refi bid”. When interest rates fall, a larger percentage of mortgages becomes economically attractive to refinance at a lower interest rate.
Whenever a threshold is breached where a large amount of mortgages make attractive refinancing candidates, prepayments spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.
Currently, I estimate that the next “refi level” will hit when the 10-year Treasury yield drops to about 2.25 per cent.
An unusual feature of this potential wave of mortgage refinancing is that the vast majority of US mortgages are on the cusp of being candidates for refinancing, given the relative stability of mortgage rates over the past year or so.
Additionally, there is one dominant holder of these mortgage securities that has vowed to reinvest in new mortgages as prepayments come in – the Fed.
Traditionally, in a refinancing rally, spreads on mortgage-backed securities widen due to increased prepayment risk and expected increases in supply. Spreads will not widen on this occasion to the same extent as during previous refi rallies for a number of technical reasons.
Among those reasons is that the Fed, the biggest mortgage investor on the block, has made clear it will reinvest principal repayments dollar for dollar. Normally, the widening in mortgage spreads mutes the impact of the rate decline on mortgage rates, slowing the pace of refinancing.
This time, advertised mortgage rates are likely to fall more rapidly than in prior refi experiences.
Selling opportunity
Given the likely rapidity of the interest rate decline, the potential for shortening in the duration of fixed income investment portfolios could further intensify the current rally and lead to a more extreme decline in rates than would normally be anticipated.
Declining mortgage rates will also give a lift to housing affordability, which could help clear unsold inventories of homes and support new construction activity. This would further support the US economy.
Ultimately, this expected run-up in bond prices and the associated decline in interest rates should prove unsustainable once the refinancing bid is past. For the near term, risks favour lower interest rates – perhaps sharply lower. In the medium term, as the economy strengthens further, this rally will reverse itself and will have proven to be a selling opportunity.
It is premature to sell now, but as 10-year Treasury yields approach 2 per cent it should provide an opportunity to rebalance portfolios. In other words, don’t chase the rally, but don’t fight it either. The opportunity to sell bonds is coming – but not just yet.
Source: http://www.ft.com/intl/cms/s/0/ece5bb60-22e0-11e4-9dc4-00144feabdc0.html#axzz3AkAuS7S0
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