M&A waves and their effects on the market

Merger and Acquisitions have been a major feature of markets for over a century and research shows they have come in waves due to market conditions, but what is the effect these waves have on the market?

Merger and Acquisition waves

     The basic principle behind these waves is a common one in the business world; there are many cycles, trends and waves in all areas from the stock markets to consumer buying. Therefore the concept is nothing new and understanding these waves gives a greater understanding to M&A's. Research has shown that these waves come in certain years for a varying length of time. 6 major waves have been identified by researchers Martynova and Renneboog (2008). The first recognised wave occurred between the late 1800's and early 1900's and the last occurred in 2007. There has been many suggestions put forward in an attempt to explain what has caused these waves. Industry and market changes have always been cited as creating opportunities for M&A's.
     The industrial revolution allowed for large industrial trusts to gain economies of scale by horizontally integrating (with companies in similar business) and creating monopolies within the market, the anti-competitive groups as a result of this were then restricted by government laws. This encouraged new methods in which companies vertically integrated to form groups in different sectors to again exploit economies of scale and this characteristic was found in the next couple of waves. Globalisation and companies' pursuit to go from trading in national markets to international markets was a new phenomena that opened up many opportunities for M&A's over the next few waves; companies took advantage of exploring new international markets that they did not have full access to before and found M&A options in their industries and those alike. From the actions presented above it could be suggested that the main driving force behind these waves is ultimately market changes and developments that come with.

The graph here shows the M&A waves from 1895 to 1995 with the peaks representing the hight of activity.

Effects on the market & Demise

     As each wave came to a decline, they all have left their mark on the market and industries. The first wave from 1897 to 1904 created monopolies within the market, especially found in the manufacturing industries which took advantage of the opportunities created by the industrial revolution. It significantly reduced the quantity of companies in the market as the smaller companies were taken over. Many saw this as a disadvantage within the market which could be controlled by the few large corporations and smaller companies were unable to penetrate the market or even start up. As a result, the controversial wave was regulated by the government which implicated policies to reduce the monopolies power and the stock market cash in 1904 ended the first wave.
     The post war economic boom and government policies allowed for companies to work together without creating monopolies; this was an effective new condition as many companies had power in the market and there were many advantages for the market under these conditions. However the 1929 stock market crash and Great Depression ended this wave and conditions were again bleak for the market. In a turn of events, the next two waves saw smaller companies acquiring larger companies and foreign takeovers could be seen; the first hostile takeover between INCO and ESB was formed during this wave and ultimately gave way to the 'poison pill'. This method is an attempt by a company to make its stocks less attractive; acting as a deterrent for a hostile takeover, this created what many saw as a difficult market place and new anti-takeover laws put an end to the wave along with the Gulf War.
     The M&A's from 1992-2000 were mostly friendly and also saw the greatest value in deals of all the waves; an economic boom created a market place full of M&A's with many top companies involved grossing a total value of $3.3 trillion. The burst in the stock market bubble ended this wave as so often happened in previous waves.

Conclusion

Each wave had different affects on the market they operated in and were characterised by. As times changed, so did the principles of the takeovers and the types of integration. Early on the M&A waves paved the way for anti-competitive takeovers to be regulated and created a fairer environment. The later waves saw the development of markets internationally but also raised the concern of hostile takeovers which were quickly countered both by companies and governments alike. Across all the waves, the effects on the market in general was an overall increase in the size of companies, globalisation and a mixture of laws both encouraging and discouraging takeovers (depending if they were hostile or not).

Dividend policies and consequences of changing

Dividend policies are crucial to a company and the relations with their shareholders and investors. Investors and shareholders have a great interest in these policies as they relate directly to the returns on the capital they have invested in a company. In terms of what policy the company will use they must decide on the value they will pay out to shareholders; this decision must be taken with caution because a policy set too high and the company may not have the finances to satisfy the payments, too low and shareholders may recognise they are not being appropriately rewarded.

Residual Dividend Policy

This policy is concerned with debt and equity; a company using this method will have a strict debt to equity ratio that it must maintain and therefore will use internally generated equity to finance any new projects. The dividend amount in this case is decided by the leftover value of equity after the project's financial requirements have been met, the downside of this policy is that if there is no spare capital post project completion there will not be any dividend value to pay and therefore a company's ability to generate its own internal equity is extremely important to keeping good relations with investors and having a hopeful future in taking on new investors. This policy does however help a business with its long term dividend policy.

Constant Growth Dividend

This policy is popular with shareholders due to agreement of growth year on year hence a boost in returns for the shareholders. On the other hand, the company must be careful what they promise shareholders in terms of their capability to grow. A company may use this method which keeps shareholders happy, the problem arises if the company does not earn as much money as it hoped to in order to pay out the increasing dividends. Two problems arise from this lack of success in its own policy: firstly they can suffer financial problems as they pay out dividends which in reality they cannot afford and secondly, the shareholders may lose confidence in the company as they witness the problem of paying out an increasing rate of dividend, which may only worsen as the years go on. On the positive side of this agreement is the benefits it can have with shareholder satisfaction assuming the company can match the increasing payout.

Constant Payout Dividend

Similar to a constant growth in that it should guarantee a payout for the shareholders but this policy agrees a constant amount that will be paid to shareholders each year without having any arrangement of growth in dividends. This has the advantages of keeping shareholders happy with their payouts on investments and also does not put too much pressure on the company to keep growing their revenue in order to increase their dividends each year.

Consequences of changing a policy

Shareholders enjoy a consistent policy when it comes to dividends which creates certainty when it comes to receiving payouts on their investments, a successful dividend policy will create a confidence amongst new investors who will be interested in the company for the future. This is a delicate position though; if a company has promised an increase in dividends each year as part of a policy change and suddenly realise the funds are not there for that rate of payout it creates tension and uncertainty within the business. On the other side of this, if the new dividend payout rate is not high enough and not in line with earnings then the rate is too low and greater dividends could and arguably should be paid to shareholders. The recent financial crisis has caused some companies to hold back on dividend payouts and this trend can also be seen in companies engaged in a merger or takeover.

Financing decisions: Equity Vs Debt

     As a business grows it must decide what method to use in order to access more capital, usually to fund an expansion in one way or another. Ultimately there are two options that most managers would consider: Equity, in the form of an investor, or debt, in the form of a bank loan. I will weigh up the advantages and disadvantages of both compared to each other which will outline which method is more appropriate.

Equity
     Whilst capital in the form of equity may seem attractive due to there not being any issue over repayments or the overhanging problem of a raise in interest rates causing your repayment to increase over time; there are still factors to consider when using an investor. As the investor will be putting their own money into the business they will usually want to have some control of the company as investors will be much more at ease with some reassurance of the activities that are being funded by their capital and perhaps more importantly they will want a hand in decision making and the direction of the business who must decide if they are willing to give up some of their control and ownership of the business for the benefit of their expansion. In terms of the advantages of equity finance the business has less pressure in relation to their performance and return on the capital. Whilst a loan requires the business to make a return in order to pay it back (with interest) capital from investors does not require a return, although investors will be expecting one, and even so they will be more willing to take a long-term view on the investment thus being less demanding on a quick return from the business.
     Another benefit which can be coupled with the desire for expansion is that the business can use the networks of the investor for new information and to increase their credibility and reputation in the market, therefore making expansion and further investment possible. Generally, with an investor the business will have more cash in hands and the finance is more easily accessible for the business. There are of course some disadvantages to this method: as mentioned before the loss of ownership can be very crucial to the efficiency of the business due to time lost of decision making; a business will be keen to invest this new capital in pre-made plans and with the investor reviewing these decisions their will be a delay and possibly and re-think to the strategy. Disagreements can lead to stressful relationships and even in extreme cases the investor making the decision; the business will need to consider the type of investor they have gone with and decide if they are the best to take the company forward. In relation to selecting an investor the process takes a long time to ensure all the right factors have been considered; this is a very time consuming process and is another example of a time constraint possibly adversely affecting the company.

Debt
     Debt finance is the alternative method which is obtaining finance through loans. This type of capital does not require the company to give up control of their operations however there is more of an emphasis on return on investment. Unlike an investor putting their own money into the company and therefore wanting some say in how the business spends its new funds and may try too have a hand in other decisions. With loan funding from banks this will not occur as the bank will not be interested in trying to run the business and therefore the company can retain the control they wish over investment activities and obtain the finance they feel they need. However, with that comes added pressure and a greater need for the business to perform. The bank will set a length of time in which the money must be paid back to them and this will include interest on the loan (increasing the amount to pay back) and penalties to the business if they do not return the investment in the form of financial fines; these will not only cause damage to the company's finances due to poor performance and fines but will also create a poor credit rating for the company which makes it much more difficult to obtain future loans. Furthermore, relying on loans to finance the company can result in a poor cash flow record causing problems when paying back the loan and perhaps even worse this can put off potential investors due to worries over the high risk of investing in the company. Perhaps the biggest risk taken with debt financing is putting up company assets as 'collateral' for the bank; these assets will be used as a security against the loan if the company fails to re-pay what is owed. This is a huge disadvantage to the company and potentially the owner as their personal belongings may also have to be put up for security if the company assets cannot cover the loan.
     As there is such a huge cost involved with repaying the loan debt finance can limit a business' ability to grow which contradicts the aim of the company to expand their operations. The company will need to consider these limitations against the potential for growth and further re-investment that comes with an investor and equity finance.


The graph below shows the equity to debt ratings of small businesses from 2000 to 2010. It shows that debt financing is much more popular with small businesses due to their smaller capacity for self raised capital. Therefore choosing between debt or equity finance heavily depends on the size of the company.

     In my personal opinion I believe that the choice between equity and debt finance should meet the company needs and situation. If a company is looking for long-term growth and willing to make internal changes and have decisions influenced by investors then equity finance provides an excellent source of capital without the pressure of repaying a loan. However, loans have always been a reliable source when investors consider a business to be high risk due to poor cash flow and as long as the company can repay the loan then it is a very good method for a business.

Advantages and disadvantages of Capital Asset Pricing Model

CAPM
     Capital asset pricing model is a tool used by investors to determine the risk associated with a potential investment and also gives an idea as to what can be the expected return on the investment. It was developed by William Sharpe along with a formula for working out the risk as  who states that with an investment comes two types of risks:
1) Systematic Risk - These are risks that cannot be diversified away such as interest rates and recessions. As the market moves and changes occur which affect the market, each individual asset is affected to some degree and therefore they are sensitive to change causing a high level of risk.
2) Unsystematic (Specific) - Can be diversified through increasing the size of an investment portfolio as this risk is specific to individual stocks and effectively represents no correlation between stocks and market movements.
CAPM states that investors are compensated for taking systematic risk however not for taking specific risk as an investor can diversify this risk away. Systematic risk cannot be eliminated of course even by holding all the shares in a stock market, therefore CAPM has introduced a method of calculating that risk.

Advantages
     CAPM has been a popular model for calculating risk for over 40 years now and is therefore a proven method, some advantages are: the focus is on systematic risk as investors have diversified their portfolios, in this case unsystematic risk has effectively been eliminated. Furthermore, in the opinion of most experts it is a more reliable and effective method of calculating risk than other models such as the Dividend Growth Model as CAPM takes into account a company's level of systematic risk against the stock market as a whole; this is a benefit as it allows for a company to compare itself to the market. An investor can also use CAPM for investment appraisal as compared to other rates its offers superior discount  rates and this model also can be clearly link between required return and systematic risk.

Disadvantages
     Despite the consistent use of the model  over the years there has been some criticism for a few reasons: firstly, CAPM is based largely on assumptions and questions have been raised over the reality of the model and the results it produces. An example of this is that no market is perfect and there is no guarantee that the market has priced the assets correctly, this again makes the formula results unreliable and cannot guarantee an investor a safe investment. To add to this borrowing for investors does not come at the risk-free rate and this can mean in reality their security market line will be shallower. In terms of competition to CAPM investment appraisal offers a more long-term perception on investment return whilst CAPM is based on a a short, single-period time where it is is perceived an investment return is assumed constant over a longer time; however this has never been proven correct and is a limitation of CAPM.

     In conclusion, CAPM is a well used model for calculating risk and return on investment, its success over the last few decades shows there are definitely some big advantages to it and I personally would recommend its use for investors. However as there are clearly some limitations to the model mostly its lack of reality and shortsightedness I would also advise other models should be used to offer a range of aspects and reduce the risk for investors.

Has Modern Portfolio Theory become obsolete? What alternatives have emerged?

Portfolio Theory
In the 1950's Markowitz developed a theory called Portfolio theory (using the MPT model) which states that when it comes to investing, the more sensible method is to have multiple investments creating a 'portfolio'. The idea being that the risk has now been spread and investments are now sounder and can increase the return on those investments. Using this theory is assuming that investors are risk averse; meaning the investor will always choose the less risky portfolio when given the option of two that give the same return. The theory looks at an assets price change in comparison to other asset price changes in the portfolio and not individually; this comparison allows for an analysis of all the portfolio and identifies which assets are riskiest. A calculation is used on the portfolio of investments to decide on the validity of investing in the portfolio which makes for a clearer and more defined analysis of risk and investment worth.

Challenges
Despite its popularity, receiving a Nobel memorial prize, there have been many in recent years who challenge the theory which begs the question 'is MPT still relevant?'. The main criticism is that MPT states that 'volatility is risk' which some do not believe to be true. For years the theory had been widely accepted, however the financial crisis threw up some interesting results concerning what would have been seen to be a placid asset in terms of its volatility; which suddenly lost all its value. Using the MPT model, these assets would have been viewed as less risky than most and would have continued to encourage investment, so long as the investment return was sufficient. Another point made by critics is that there has never been any proven correlation between risk (as volatility) and return; cannot prove that high volatility gives better results and low volatility produces lesser results. Considering that volatility is the main factor in determining whether returns will be high or not according to MPT, this is a major challenge to the theory and is now the reason that the theory is questioned so much.

Is it still relevant?
The financial crisis of recent times has been an anomaly that made many question MPT and is perhaps the answer to the question on it's own; whilst years ago MPT was accepted, new scenarios that have appeared in the last decade have proven that MPT does not always work and may now be outdated. In my opinion, for your safe, non-volatile asset to lose all its value during a crisis, is a very devastating blow to the theory and will make investors second guess their use of the theory, perhaps dubbing it behind the times. However, challenging the theory purely based upon the financial crisis is not full-proof and investors must consider that diversification, while not being completely successful, has certainly offered much protection against risk in the past and may have even helped investors make less of a loss in the financial crisis than if diversification had not been employed.

Alternatives to MPT
One alternative to MPT is something called 'timing the market'. This can be seen as common sense among investors; the principle being that you hold an asset when its value is good, giving positive returns and when things start to go 'bad' for the asset you sell. This can return huge gains on an investment as the theory behind it is so obvious and simple; however a major factor in this method is investors almost need a crystal ball to ensure they can predict what will happen to the value of an asset.
Finally, something that must be considered is the idea of 'Black Swans' those assets which appear to be random and by the large majority of the market completely unpredicted. These would appear to make it impossible for the market to measure risk and therefore can any of the theories or practices be reliable enough to use as a motor for investment.

Conclusion 
There is little doubt that MPT has some viable aspects and understands the role that volatility has upon the markets and investments; personally I agree that volatility is risky and must be taken into consideration by all especially since investors are risk adverse. I also think that the financial crisis was an anomaly which could not be predicted or protected against by any theory or practice. Despite this, the financial crisis has definitely proposed some challenges to MPT which any intelligent investor would consider; the main principle of volatility directly correlates to returns has never been conclusively proven and the smallest bit of doubt is enough to make risk adverse investors hesitate. These findings would suggest that MPT has become slightly outdated and there is a good case against the theory, on the other hand, its principles can still be used today and few alternatives have been presented.

Opposition to EMH: Can the market be beaten?

     With stock market prices fluctuating so frequently, especially just prior to announcements, many buyers try and 'beat' the market and predict movements in order to return abnormal yields on their investments.

Fama and EMH

There has been much discussion regarding the ability to be able to predict and with this developed the Efficient Market Hypothesis partly created by Fama; this states that any new information about stocks are already reflected in the share prices and therefore those who believe they have an advantage through new knowledge will not be able to take that advantage because the prices will have changed appropriately and the market reacts completely randomly (Investopedia, 2013). Due to Fama's hypothesis he states that there is no reason to study previous movements or use investment advice from experts claiming to know how the markets will react, it is all, as Fama claims, a waste of time and an attempt to achieve the impossible.
There are three forms of effective market hypothesis: Weak form states that prices already reflect all past publicly available information, the semi-strong form backs this and goes on to say that any new information released is reflected in changes to prices. Many believe that if they have knowledge not known to the public, such as 'insider' knowledge then they will have an advantage and can use the knowledge to return greater yields, however the third form, strong, states that even insider knowledge is reflected in share prices and therefore even insider knowledge is ineffective (Boundless).
Fama also stated predicting the stock market is like taking a random walk due to the speed at which the market reacts to new information, therefore it is impossible to predict (Vulić)

Opposition to the hypo-theory

As with all theory's there is competition to EMH who believe the market prices can be predicted and abnormal gains made. Many tests have been completed in order to test the effectiveness of EMH, most popular of these is the Augmented Dickey–Fuller test but there have been many more analysing different aspects of EMH and stock markets. Technical analysis, which analyses past price actions to advise for future trades, directly opposes the idea that a market is completely random and believes that past trends can be used to predict. Neely (1997) proposed three elements of technical analysis: the first being that price movements reflect hopes, fears, greed and optimism of the stock market participants, many believe stocks are valued not at their value but what people believe their worth to be. The second and third principles both involve the idea that history and trends are very helpful, they hold the belief that history and trends do not suddenly become random and do follow a pattern as people will always react the same way (Dixon, 2005). In my opinion the emotional make-up of investors does not always remain the same and past trends will also not remain consistent throughout trading years.

Conclusion
The debate of whether or not you can predict or even 'beat' the market will always be one of issue and will split many opinions and continue to be tested. In my opinion I do not believe anyone can be sure that past trends are likely to predict current trends and as EMH states, even new information leaked is reflected in share prices especially as investors are now able to react so quickly to information.Therefore, whilst some may be able to return abnormal yields on investment, it is not due to analysis rather than anomalies and I do not believe the market can be effectively and consistently beaten.