Greenbackd

The Wall Street Journal’s Deal Journal blog has an article, The Secret to M&A: It Pays to Be Humble, about a KPMG study into the factors determining the success or otherwise of M&A deals over the period from 2002 to 2006. Some of the results are a little unexpected. Most surprising: acquirers purchasing targets with higher P/E ratios outperformed acquirers of targets with lower P/E ratios, which seems to fly in the face of every study I’ve ever read, and calls into question everything that is good and holy in the world. In effect, KPMG is saying that the relationship of value as a predictor of investment returns broke down for the period studied. I think it’s an aberration, and I’ll be sticking with value as my strategy.

In the study, The Determinants of M&A Success What Factors Contribute to Deal Success? (.pdf), KPMG examined a number of variables to determine which had a statistically significant influence on the stock performance of the acquirer. Those variables examined included the following:

• How the deal was financed—stock vs. cash, or both
• The size of the acquirer
• The price-to-earnings (“P/E”) ratio of the acquirer
• The P/E ratio of the target
• The prior deal experience of the acquirer
• The stated deal rationale
• Whether or not the deal was cross-border

KPMG found that some factors were highly correlated with success (for example, paying with cash, rather than using stock or cash and stock) and others were not statistically significant (surprisingly, market capitalization). Here are KPMG’s “key findings”:

• Cash-only deals had higher returns than stock-and-cash deals, and stock-only deals
• Acquirers with low price-to-earnings (P/E) ratios resulted in more successful deals
• Those companies that closed three to five deals were the most successful; closing more than five deals in a year reduced success
• Transactions that were motivated by increasing “financial strength” were most successful
• The size of the acquirer (based on market capitalization) was not statistically significant

The P/E ratio of the target is correlated with success, but not in the manner that one might expect:

The P/E ratio of the target was also statistically significant. In contrast to our previous study, acquirers who were able to purchase companies with P/E ratios below the industry median saw a negative 6.3 percent return after one year and a negative 6.0 percent return after two years. Acquirers who purchased targets with P/E ratios above the median, including those with negative P/E ratios, had a negative 1 percent return after one year and a negative 3.5 percent return after two years. These results are very different from the ones we found in our last study for deals announced between 2000 and 2004. Those earlier deals demonstrated the more anticipated results: acquirers who purchased targets with below average P/E ratios were more successful than acquirers who purchased targets with higher P/E ratios.

It is probable that in the deals announced between 2002 and 2006, acquirers who purchased targets with high P/E ratios were buying businesses that were growing and where the acquirer was able to achieve greater synergies. Deals announced between 2000 and 2004 included deals from the “dot-com” era, where high P/E ratios were often associated with unprofitable ventures that were not able to meet future income expectations.

Here’s the chart showing the relative returns to P/E:

Now, we value folk know that, in any given instance, the P/E ratio alone tells us little about the sagacity of an investment. In the aggregate, however, we would have expected the lower P/E targets to outperform the more expensive acquisitions. That’s not just wishful thinking, it’s based on the various studies that I am so fond of quoting, most notably Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk. Lakonishok, Shleifer, and Vishny found that “value”determined on the basis of P/E consistently outperformed “glamour”. That relationship seems to have broken down over the period 2002 to 2006 according to the KPMG study.

There are several possible explanations for KPMG’s odd finding. First, they weren’t directly tracking the performance of the stock of the target, they were analysing the performance of the stock of the acquirer, which means that other factors in the acquirers’ stocks could have influenced the outcome. Second, five years is a relatively short period to study. A longer study may have resulted in the usual findings. Third, it’s possible that 2002 to 2006 was a period where the traditional value phenomenon broke down. It was a big leg up in the market, and a bull market makes everyone look like a genius. Perhaps it didn’t matter what an acquirer paid. That seems unlikely, because the stocks of the acquirers were generally down over the period. Finally, KPMG might have taken an odd sample. They looked at acquisitions “where acquirers purchased 100 percent of the target, where the target constituted at least 20 percent of the sales of the acquirer and where the purchase price was in excess of US$100 million. The average deal size of the transactions in this study was US$3.4 billion; the median was US$0.7 billion.” Perhaps that slice of the market is different from the rest of the market. Again, that seems unlikely. I think KPMG’s finding is an aberration. I certainly wouldn’t turn it into a strategy.