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Betting on the binge

Following on from the likes of Dairy Crest, Merlin Entertainments (MERL) and Cobham (COB), which have been – or are in the process of being – gobbled up by exchange-rate-enriched predators, pubs operator Greene King (GNK) is ready to give up its 200-year-old independence. In arguably what is the most generous takeover bid London has seen since Masayoshi Son’s Softbank (TSE:9984) swallowed microchip designer ARM for £24bn in 2016, Hong Kong property investor CK Asset (SEHK:1113) is offering £2.4bn – or 850p a share – for the Suffolk-headquartered group.

CKA’s offer looks generous because it is 51 per cent higher than Greene King’s close the day before the announcement and 80 per cent above its 12-month low (plus – for what it’s worth – 48 per cent more than the Bearbull portfolio paid 15 months ago). However, that does not make it foolish. Generosity, as Masayoshi Son has repeatedly demonstrated, avoids the time and cost of haggling over price and minimises the risk of losing out to a rival.

Besides, Greene King’s share price was within spitting distance of £10 less than four years ago and CKA – best known for being formed out of a merger with Hutchison Whampoa, a venerable British-controlled Hong Kong company – is offering barely more than 13 times this year’s likely earnings, a multiple that surely would give it an upfront return higher than its cost of capital.

And then there is the currency issue, which is actually a bit more than about exchange rates alone and is tied to Brexit. Champions of Brexit protest that the UK unchained will be invigorated by innovation, but share prices suggest that more likely it will be a victim of enervation. From the perspective of overseas buyers there is more than just the depreciation of sterling. There is also the effect of declining expectations for UK corporate performance.

This is best illustrated by the table below, which is an abridged version of a real-time spreadsheet I keep on my desktop. It shows the performance of major financial markets in terms of both local currencies and sterling.

 

How UK equities have lagged behind
Equity indicesNow-1 yr-3 yrs-10 yrsCh on 1 yr (%)Ch on 3 yrs (%)Ch on 10 yrs (%)
FTSE All-Share3,9534,1393,7562,469-4560
S&P 500 ($)2,9262,8972,180995134194
S&P 500 (sterling)2,3992,2281,639610846293
Nikkei 22520,70422,70716,92610,280-922101
Nikkei 225 (sterling)160.0157.8122.168.4131134
Sterling versusNow-1 yr-3 yrs-10 yrsCh on 1 yr (%)Ch on 3 yrs (%)Ch on 10 yrs (%)
US dollar1.221.301.331.63-6-8-25
Swiss franc1.211.261.301.73-4-7-30
Japanese yen129.42143.86138.59150.33-10-7-14
Hong Kong dollar9.5510.1910.3112.60-6-7-24
CommoditiesNow-1 yr-3 yrs-10 yrsCh on 1 yr (%)Ch on 3 yrs (%)Ch on 10 yrs (%)
Gold1,5231,1941,323977281556
Gold (sterling)1,2489189945993625108
Source: S&P Capital IQ       

 

Take the most glaring contrast – that between the performance of the FTSE All-Share index and the S&P 500 index of leading US stocks over the past 10 years. Even before the effect of sterling’s decline, the performance of UK shares is pedestrian – a rise of 60 per cent compared with 194 per cent for the S&P 500.

Sure, some of the S&P’s rise can be attributed to the so-called ‘exorbitant privilege’ that all financial things American enjoy by being attached to the world’s de facto reserve currency, the biggest economy, the biggest markets and so on. Even so, the relative performance surely owes something to the perceived future shortcomings of UK companies too. After all, as the table shows, the All-Share has also badly underperformed Japan’s Nikkei 225 index – 60 per cent against 100 per cent over the past 10 years.

Factor in the effect of the pound’s decline and the performance gap becomes wider – a 293 per cent gain for the S&P index in sterling terms against 60 per cent for the All-Share; 134 per cent for the Nikkei average in sterling.

That gives predators – especially from the US – usefully more buying power over UK assets. Imagine two companies of equal size 10 years ago – one British, one American – then factor in the combined effect of the relative rise of US equities and the decline in sterling. As a result, the US company would now be two-and-a-half times bigger, and what would have been an impossible acquisition of a London-listed company 10 years ago would now be feasible.

Even over three years – a start date that is after the UK’s vote to leave the European Union but before Article 50 was triggered – the difference is significant. The market value of the theoretical US company would have become 40 per cent bigger than its UK counterpart. Small wonder that US interests – mostly private equity – are queuing up to buy UK companies.

That said, there are limits to how far this argument will go. Over the past 10 years, Chinese companies – including those from Hong Kong – have not had the tailwind of an outperforming stock market. Both China’s CSI 300 index and Hong Kong’s Hang Seng index have underperformed the All-Share in local currencies. However, in addition to fast-growing domestic markets, predators from both China and Hong Kong have benefited from exchange rates. This is especially true of those from Hong Kong, whose own dollar is closely tied to the US dollar. As a result, a typical Hong Kong company would have generated an extra 13 per cent of buying power over UK companies in the past three years.

That’s useful without being significant. Though in CKA’s case, it hardly matters. Its share price has marked time since it merged with Hutchison in 2015, but its market value of about £20bn makes it eight times more than the price it plans to pay for Greene King. That makes Greene King a full-size meal rather than a tasty morsel, yet CKA’s bosses are hardly betting their company on the acquisition.

From this, the almost-inevitable question arises: what sort of London-listed companies are most likely to appeal to foreigners with enhanced buying power? From the five notable transactions so far this year, no clear pattern emerges.

There is a sort-of focus on UK consumers in the bids for Dairy Crest, Merlin Entertainments and Greene King, although Merlin and Greene King are further towards the discretionary end of the spectrum. Entertainment One (ETO) – best known for its pre-school cartoon character Peppa Pig – is a Canadian company that just happens to have a London listing. So its agreed acquisition for £3.3bn by US toys and games maker Hasbro (US:HAS) has much to do with sterling’s weakness; although for Hasbro the hope is that the deal will fill a gap in its product portfolio in much the way that the acquisition of HIT Entertainment – best-known character, Bob the Builder – did for its smaller US rival Mattel (US:MAT). Meanwhile, defence supplier Cobham – on the end of a £4bn bid from US private equity – is very much a capital goods company.

True, it's tempting – though often futile – to look for patterns where they don’t really exist. Qualitatively, however, there are some sorts of businesses that will always be of interest if the price is right. The boxes that such companies tick include: high-quality businesses (with the financial ratios to prove it); market-leading positions (regionally as well as in products or services); capable of generating economies of scale; customer captivity; easy to understand (the accounts as well as the firm’s activities); good at generating cash.

Granted, this is pretty much a generic checklist and any company that – given some latitude – gets several ticks is going to be in the frame. In which case, the challenge might not be in assessing which London-listed companies are candidates but where to stop, given that there would be so many.

I exaggerate, but the underlying point is that there are many high-quality companies on the London market that would be worth a close look to predators bristling with ambition and bulging with buying power pumped up by strong currencies. Even in just those sectors occupied by the five targets mentioned above – discretionary consumer, media and industrials – with no effort I rounded up 20 candidates that, intuitively, look like ideal prey.

I would prefer to keep their identity under wraps until I’ve done some number crunching. After all, some intuitive notions will turn out stupid and some glaringly obvious candidates may have been missed. As a taster, however, Hollywood Bowl (BOWL), Carr’s (CARR) and Wincanton (WIN) seem plausible, as – happily – do two more from the Bearbull portfolio, Vesuvius (VSVS) and Elementis (ELM). After a break, Bearbull will be back at the end of the month.