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Benefits and Pensions MonitorThe Hidden Value Of Equities
Structural demand for equities is buoyant – a development overlooked in recent years as attention has focused on asset allocators shifting away from equities into bonds. However, as pension funds have been selling equities for liability matching requirements, private equity and activist shareholders have been leading the cause to ʻunlock shareholder value.ʼ Driven by their search for alpha in a market environment of low yields and low volatility, these investors have sought to push share prices higher, either through outright buyouts or activist shareholder strategies. The effect has created a demand premium in equity markets, where net buying is meeting (or exceeding, in the case of the UK) net supply. Figure 1 shows a slowing in world equity market growth within a narrow definition of overall net issuance versus supply. Historically low interest rates have provided the financing conditions to allow private equity investors to borrow cheaply to fund acquisitions and delist companies. In the first half of 2006, global volume for leveraged buy-outs (LBO) totaled $85.5 billion – a 48.7 per cent increase year-on-year.1 At the same time, net equity buying has been reinforced by activist shareholders. Without the capital risks associated with an outright acquisition, there has been an increasing trend for such investors, particularly hedge funds, to buy a large stake in a company (typically less than 20 per cent of its market value) that is sufficient to influence management strategy. The attractiveness of LBO and shareholder activism opportunities has been greater as investors have sought to release the unusually large cash positions of companies. In effect, equity markets are potentially undervaluing companies which have accumulated strong cash positions, but have yet to make efficient use of their balance sheets and realize shareholder value. For the current S&P 500 non-financial companies, free cash flow as a percentage of total debt is near peak levels at 22 per cent, compared to the average level of 15 per cent since 1995.2 But, rather than increasing capital expenditure, companies appear more willing to use strong cash flow levels for shareholder enhancement activities. The U.S. market has seen a sharp increase in share buyback activities since the fourth quarter in 2004. During the second quarter of 2006, the market value of buybacks totaled 3.3 per cent (annualized) within the S&P 500.3 Often, share buybacks can be a principle tool to dissuade shareholders from accepting private equity buyout offers.
Hitherto, private equity and activist investors have been assiduous buyers of small- and mid-cap stocks that may be targeted for de-listing or in anticipation of a corporate event. Not by coincidence, smalland mid-cap stocks have outperformed larger-cap stocks in the last six years, and arguably suppressed a much anticipated performance rotation into the large-cap area. Typically, small- and mid-cap companies trade at a price/earnings (P/E) discount relative to large-capitalization companies, reflecting their higher risk and greater volatility. However, this discount has been eliminated and smalland mid-caps now trade at a slight premium to large-caps. In September 2006, the P/E ratios for U.S. small- and mid-cap stocks were 18 and 17.6, respectively, while U.S. large-cap companies traded at a P/E ratio of 17.1.4 Target Larger Companies As large-cap stocks represent relative value against their smaller peers, we are seeing a concurrent trend for private equity investors to target larger companies. The average deal size reached a peak in the first quarter of 2006 at $1.23 billion and companies once considered too gigantic for LBOs appear not to be off limits.5 Nine of the 10 largest buyouts in history have been announced in the last 18 months. While large-cap stocks may find support from potential private equity demand, they also trade at a discount relative to their recent history, particularly growth stocks. The P/E ratio for the S&P 500 is currently trading at a level last seen at the start of the previous market cycle in 1995. Although corporate earnings growth is likely to moderate in the second half of this year for S&P 500 companies, following 13 consecutive quarters of double digit growth, the strength of corporate cash holdings, together with reasonable P/E ratios, should help to underpin equity market valuations. Notwithstanding an apparent discount of large-cap equity market valuations, the influence of private equity and shareholder activism on stock market behaviour is arguably raising the importance of fundamental stock-picking. With credit fundamentals of companies under greater scrutiny from investors, those share prices that show potential valuation anomalies will be rewarded. Unequivocally, finding these opportunities will be dependent on a fundamental research approach as opposed to one that is top-down.
1. Credit Sights 2. JP Morgan, 2006 Midyear Investment Grade Credit Outlook 3. Citigroup 4. Leuthold Group and T. Rowe Price 5. Credit Sights |
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Arvind Sabharwal is a U.S. equity portfolio specialist with T. Rowe Price Global Investment Services. Fiona Leonard is communications manager, ICM. 