Robert F. Bruner - Applied Mergers and Acquisitions

Credit ratings. Publicly traded debt issues are ordinarily rated for creditworthiness by rating agencies. Here, “creditworthiness” refers explicitly to risk of default in servicing the issue. The analyst should scrutinize the ratings of issuers in the target industry for consistency among the players. Outliers will have an interesting exposure to strategic forces. Also, rating changes are unusual and especially noteworthy—the acquisition analyst will find in these events one or more strategic themes. But it is also important to note that rating changes usually occur well after investors have recognized the need for a change. A better and more timely focus of attention would be the risk premiums for corporate debt over the yield on contemporaneous government debt issues.

Maturity or duration for typical debt issues. The maturity structure of a firm’s liabilities offers clues about the expectations of insiders and creditors about the firm’s future cash flows, and about the nature of the assets standing behind those debts. The acquisition search analyst could compare the maturity structures for firms in a target industry, and check the extent to which those structures have changed over time. The classic advice to corporate borrowers is to set the life of their liabilities equal to the economic life of their assets. To mismatch these two lives is to expose the firm to financial risk. 19 While it is notable that most firms ignore this advice, it is a useful starting point for the analyst since the direction of the mismatch can help the search analyst reveal strategic themes. The main difficulty with maturity matching analysis is in determining the average maturity of a firm’s assets; there is no rigorous way to do this.

Covenants or security pledges for typical debt issues. Lenders and investment bankers who specialize in financing a given industry can offer insights into the practices of structuring corporate debt issues in those industries. The reasons for those practices often give fascinating insights into the risks and strategic themes faced in those businesses.

Public corporations have several trillion dollars of equity securities outstanding on global markets. Equities offered three avenues of exploration for acquisition search analysts: multiples, betas, and charting/market sentiment.

Pricing multiples are a commonly used tool of analysis in the global financial markets and give a convenient indication of the price of an asset relative to some benchmark, such as the earnings from that asset. Chapter 9, “Valuing Firms,” gives a more detailed review and commentary on the varieties of multiples one could examine; that review will not be duplicated here. A hunt for strategic themes could examine multiples across the players in an industry, and over time.

This is a measure of the historical volatility of a firm’s share price relative to the entire stock market. More precisely, it measures the degree to which investors in that firm’s shares will assume systematic risk, or risk that cannot be diversified away through portfolio diversification. Ordinarily, betas for firms in the same industry will tend to cluster together around a similar value. Outliers should be studied for causes of their different risk. Also, using the Bloomberg financial data retrieval system, one can estimate betas for firms over different historical periods, and thereby determine the extent to which their systematic risk is changing. Betas have a statistical tendency to drift toward the value, 1.0, over long time periods. Bloomberg and other sources report raw betas, as well as betas that have been adjusted for their drift. Both betas should be studied. Sudden material changes in beta, especially away from 1.0, can be clues about strategic themes.

It is possible that examining the height, direction, and rate of change of stock prices will yield insights into strategic themes. Charting is a branch of securities analysis that seeks to derive insights about the future path of stock prices from their recent trends. Chartists presume that securities prices are driven largely by market psychology, rather than by economics. The discussion in this chapter, and throughout this book, presumes otherwise, for there is little scientific evidence that these techniques assist an investor in finding exceptional investments. But the task in this instance is to identify strategic themes of creative destruction, rather than to predict investment returns directly.

It may be possible that charting measures can reveal important themes not evident in the other approaches reviewed here. The acquisition analysts should consider classic charting measures as possible sources of themes. Indexes of “odd lot” trading show the relative presence of small-volume traders in the market—an “odd lot” trade has less than 100 shares. The belief is that odd-lotters are relatively unsophisticated traders who get sucked into purchasing shares near the end of a long run-up in prices, and into selling shares near the end of a long decline. In short, the conventional chartist point of view is that odd-lotters buy high and sell low. Some chartists follow statistics on short sales . In these transactions, the investor has sold shares that he does not own, in expectation of a stock price decline, after which the shares will be repurchased, and the position closed out at a profit. An increase in short-sale positions may indicate pessimism about a firm or industry.

Chartists follow various confidence indexes , one of the most common being the ratio of average corporate bond yields to average dividend yields. An increase in the confidence index is believed to signal optimism; a decrease, pessimism. Relative strength statistics measure the extent to which a firm’s stock price moves faster or slower than the general market. Changes in relative strength would signal optimism or pessimism. Volume of trading data gives insights into the extent of action in a firm’s shares. Sudden and material increases in trading volume may signal the arrival of new expectations about the firm. Finally, moving average analysis affords chartists a benchmark against which to assess daily price movements: a downward penetration of a moving average line suggests selling pressure; an upward penetration suggests buying pressure.

Open derivatives positions of all kinds on global markets carry an enormous notional value. Of most interest to the analyst would be standardized derivatives contracts on corporate securities, particularly in the options and futures market. Of greatest interest here will be the implied volatility embedded in the pricing of these derivatives. Volatility is a measure of the uncertainty or risk that derivatives traders and investors perceive in the price of the underlying security. These securities are said to “trade on risk” rather than on price since the investor must make a judgment about risk in assessing the price of the security. One source of possible themes would be a cross-industry comparison of volatilities of players in an industry. Another possible source would be to examine the time trend of volatilities for players in an industry for any changes in the direction and magnitude of their risk trends.

The bottom-up approach is essentially a hunt for interesting anomalies. This can be surveyed in two ways: where to research and how. Research must be governed by the rule, “Stay close to facts.” This means relying on one’s primary research over that of secondary intermediaries who might predigest data, and seeking instead to absorb unrefined information. Business development analysts rely on sources as diverse as these: store visits, conferences and conventions, newspaper want ads, trade magazines and newsletters, focus group responses, and so on. Each industry segment has its special surveys and pools of interesting data. Rumors and word-of-mouth reports of the sort that your firm’s field representatives will hear are valuable to the extent that they come directly from a credible source. Annual reports and SEC filings of peer firms, customers, and suppliers offer detailed financial insights.