Market commentators have written widely about their expectations for global equities in 2013. These have largely (and slightly worryingly!) been substantially positive, highlighting that, despite their strong returns in 2012, equities remain cheap by historic standards. Pro-active cost cutting and shrinking borrowing costs have maintained historically high corporate profit margins, and companies (excluding banks) have extremely strong balance sheets, many in the enviable position of holding excess net cash. And for the long term investor, there is the enticing prospect of institutions at long last increasing their allocation towards equities, as bonds (particularly sovereigns) offer increasingly unattractive investment returns ahead. I agree with all the above, although the institutional argument is the proverbial oil tanker which will take a decade to change its anti-equity direction. All these arguments do, however, focus entirely on the demandside of the equity equation.
So what about the supply side of equity? Global merger and acquisition volumes peaked in 2000 thanks to “dot com” euphoria, and had a second, smaller, spike in 2007 coinciding with the peak of equity markets. Equity issuance was high, as companies took advantage of their overvalued stock to issue more as they expanded. As basic economics suggest, a little falling demand combined with an increasing supply of equity sowed the seed of falling prices ahead in both instances.
It is conceivable that we are approaching a period when the converse could be around the corner. Cheap equity prices, strong balance sheets, high return on equity and historically low bond yields are an attractive combination, which companies are increasingly taking advantage of. There are many ways in which the supply of equity could contract. Unlike 2000 and 2007, with many companies now struggling to grow their sales, acquiring a close competitor may provide an attractive combination of cost cutting and reduced competition. Increasingly, such transactions have been made with cash, thus creating greater value, and with a lower supply of equity. Similarly, cash rich companies earning next to nothing from their deposits are increasingly itching to use their cash more efficiently. If Apple can generate a return on equity of 42 per cent, why hold cash yielding a fraction of a percent? By simply buying back stock they, and others, can instantly show strong improvements in earnings per share. A third route for shrinkage in equity supply is through management buy outs. These have been sparse of late but, as I write, Dell are rumoured to be lining up a $20 billion deal to take itself private. If successful, this would be the largest leveraged buyout since July 2007.
Cynics will reply that these conditions were prevalent in 2012, so why is it going to change in 2013? There are two big differences in my mind. The first is that, whereas bond yields collapsed for the best quality companies last year, those lower down the credit spectrum were far less able to raise finance. Spreads have narrowed sharply in recent weeks, so broader bond issuance would seem likely, and will remain well supported by quantitative easing and bond buying programmes across the world. Secondly, and more anecdotal, is that in a period of collapsing economic confidence companies feel safer holding higher levels of cash. It is only when stabilisation occurs that they may begin to consider a more efficient capital structure. For most companies that means a combination of more debt, less cash and less equity. It is conceivable therefore that we are approaching the sweet-spot for equity supply. In 2011 and 2012 economic uncertainty was too high and at some point in the future, maybe 2015, bond yields will begin to normalize, removing the exceptional funding opportunity. 2013 and 2014 therefore provide the optimum moment for equity supply to materially fall. Add supply contraction to increasing demand and the outlook might look considerably rosier than many think!
Mike Jennings is CIO and manager of the Premier Global Strategic Growth fund