A pick-up in mergers and acquisitions activity in undervalued parts of the US equity market could start a transition away from mega cap technology and Internet names being the biggest drivers of performance and momentum.
The strong performance of U.S. stocks over the last several years has overshadowed a bifurcated market. Mega cap technology and Internet names have flourished, generating the majority of market gains on the strength of solid performance and buying momentum from passive strategies. Large swaths of the market, however, have lagged, with valuations remaining sluggishly below historical valuations.
We have seen these patterns occur a number of times during our tenure managing the fund, where the most crowded stocks or sectors eventually cede their leadership position. A market sell-off is often a trigger for this shift, however, we believe an increase in merger & acquisition activity that serves to monetize undervalued assets could also spark a transition.
Several catalysts could drive a pickup in consolidation across a number of sectors. Deal financing remains cheap by historical standards as continued low interest rates make it easier for companies to borrow. Many U.S. corporations also sit on large cash piles while the companies we target generate healthy levels of free cash flow that can be tapped to fund M&A activity. The potential for repatriation of as much as $1 trillion in overseas profits, a component of President Trump’s corporate tax reform proposals, could make more cash available to finance deals – especially among technology and health care companies with the largest offshore cash hoards. The Trump administration is also expected to make a more positive stance to deals from a regulatory standpoint.
Three areas of the market we favour could be poised for deal making: media, energy and health care.
The media sector most recently saw a wave of consolidation among content distributors. Today we are beginning to see an uptick in activity among content providers. As the means of distribution increases, with web streaming playing a more significant role, programmers need more assets to gain scale, pricing power and create better content bundles. The Lionsgate Entertainment-Starz and Discovery Communications-Scripps Networks tie-ups could be a sign of things to come. Rather than going the costly route of producing original programming, more companies are opting to purchase content through M&A. We expect that streaming leaders Netflix and Amazon.com could eventually choose this option.
The energy sector also appears poised for a pickup in deal making as companies in the exploration & production (E&P) industry have become more attractive buyout candidates. Through the commodity downturn, E&Ps cleaned up their balance sheets, took costs out of their business and focused on owning productive, low cost assets. Anadarko Petroleum, for example, could be a buyer of assets to expand its geography or could be the target of an integrated oil major looking to buy high-quality oil & gas acreage. We expect that consolidation within energy will start with asset sales and eventually lead to full company acquisitions. At some point, Exxon Mobil or Total could make a significant purchase.
In health care, large, cash-generative biotechnology and pharmaceutical are seeking ways to enhance growth and fund future research & development. Conversely, smaller companies have products and technologies that offer growth, but often lack the resources to realize the value of their opportunities. While lower valuations have impeded smaller companies from selling, there now appears to be greater comfort with striking deals off of reset valuations. We expect some early stage companies with limited financing options to turn to larger players for the cash to fund R&D. Attractive valuations of biotech stocks relative to their growth rates also increase the likelihood these companies will be monetized through deal activity.