Which US sectors are poised to gain on wave of merger activity?

US-USA-America-Rally-Flag-700.jpg

Growth remains elusive across much of the global economy. Even the US – a stalwart compared with others for most of the current recovery – has recently showed signs of sluggishness. The country’s economy expanded by just 0.5 per cent in the first three months of the year, held back by weakness in capital expenditures by businesses and lower-than-expected spending from consumers.

On the profit front, US companies posted a third consecutive quarter of earnings declines in Q1, the longest period of such weakness post-financial crisis. Overall earnings have been dragged down by the commodity recession, which has most severely impacted the energy, materials, industrials and financial sectors.

In such an environment, companies have limited options to generate revenue and earnings growth. US corporations continue to sit on large cash piles and many generate healthy levels of free cashflow that are being tapped to fund share buyback programmes. While buybacks act to improve earnings per share and can provide a supportive bid to equity prices, they tend to be more of an accounting manoeuvre than a sign of growth.

Another option for companies is to buy growth through mergers and acquisitions. Last year witnessed a record level of M&A activity by deal value, with $3.8trn in transactions. After a slow start to 2016 due to heightened levels of market volatility, deal volume is beginning to pick up and the conditions remain in place to support continued consolidation.

Deal financing remains cheap by historical standards as record low interest rates are making it easier for companies to borrow. Financing should remain easily available to potential acquirers as the US Federal Reserve has pared back its plans to raise interest rates.

Several sectors in particular appear poised for continued deal-making in the year ahead. Healthcare was at the centre of consolidation activity in 2015 and, judging by the surge in volume last month, should remain a robust area.

Early in April, Pfizer terminated its planned acquisition of biopharmaceutical rival Allergan after the US Treasury announced surprising new regulations that negated the significant tax benefits from the transaction. However, three significant new deals were announced at the end of April.

We expect to see more M&A activity going forward. Large, cash-generating companies want to enhance or extend growth. All healthcare players have been getting larger and companies need to maintain competitive scale with their peers and their customers, while debt remains cheap for larger borrowers.

Conversely, smaller companies have products and technologies that offer growth, but often lack the resources to realise the value of their opportunities. Resource constraints have been exacerbated by the biopharmaceutical sector correction, reducing companies’ ability to raise capital. While lower valuations have also 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 cut off from financing to turn to larger players for the cash to fund research and development.

The energy sector also appears poised for a pick-up in deal-making, as stronger players look to take advantage of distressed pricing to acquire smaller competitors that would otherwise face bankruptcy or scoop up select, high-quality assets.

Energy companies with best-in-class balance sheets and solid liquidity profiles run by management teams skilled in operating through stress can continue to invest when competitors are struggling to survive. While the current environment is focused on managing costs and preserving value for energy companies, we think the survivors will be winners long term.

A lack of organic growth is also motivating companies to engage in mergers of equals, hoping to benefit from significant cost-cutting and economies of scale. We have witnessed this most recently in the technology sector.

Across industries, companies that can generate their own growth and invest in their businesses should eventually see that additional value monetised, be it through share price appreciation or through takeovers – a strategy we see as a leading generator of growth and stockmarket performance in the near term.

Evan Bauman is manager of the Legg Mason ClearBridge US Aggressive Growth fund