STEPHEN MARTIN

It seems to be another day, another deal. Whilst the potential tie-up between Asda and Sainsbury’s grabbed headlines, CYBG showed it’s not the only show in town with a sweetened bid for Virgin Money earlier this month. In fact, Asda and Sainsbury’s wasn’t even the only story the day it was confirmed: in the space of 24 hours, a number of transactions valued north of £100 million were announced.

To a certain extent, mergers and acquisitions (M&A) are a common occurrence - they account for billions of pounds of economic activity annually. Consolidation of markets is also inevitable, particularly where they are fragmented or inefficient.

In that respect, certain sectors look ripe for further M&A. Media, for one, is disjointed, with more deals likely to follow Reach’s (formerly Trinity Mirror) purchase of Northern & Shell’s newspaper titles for £184 million. Only the other day, Comcast made a $65 billion bid for most of Fox’s assets.

Pharmaceuticals is another market that could see further consolidation. Takeda and Dublin-based Shire agreed terms on a £46 billion takeover in May – albeit, moves are being made to block that deal. Yet, with research from the Tufts Centre for the Study of Drug Development putting the average cost of getting a drug to market at $2.7 billion, identifying opportunities for economies of scale is the only rational option. Ironically, this deal offers little by way of research synergies, so it will be interesting to see if it does eventually get approved by shareholders.

The technology sector, where there are a multitude of players with small market shares, looks another potential candidate. So too does the construction industry, where sluggish growth in the first few months of 2018 points to an industry struggling for confidence and dealing with stubbornly tight margins.

However, deals don’t happen in isolation – they’re heavily influenced not only by the balance sheets of the companies involved, but the wider economic picture too. In fact, consolidation on the scale we’ve seen in the past few months usually points towards a threshold in economic theory: the cycle is approaching its latter stages.

While companies may merge to improve profitability, it often implies they cannot grow their top lines organically. Instead, they find themselves having to buy someone else’s sales or look at ways of combining processes and stripping out cost.

Sadly, companies often pay too much for another business, in a frantic bid to grow revenues or boost profitability. When that happens, it can mean a deal might not be as profitable as hoped – or they fail to find the synergies initially expected. Cutting costs often means cutting capital expenditure, and this has painful consequences, typically many years later, when the supply of new products dries up.

Normally, the quantity, character, and size of these deals would suggest there are more turbulent times to come. To go a step further, in a normal economic cycle, they would indicate recession is coming into view on the horizon.

However, this isn’t a normal economic cycle. After years of central bank intervention in global economies through quantitative easing, we have a distorted market. Interest rates and bond yields have been at record lows, triggering a different economic cycle to what would typically have been expected. That’s also helped relatively weak companies stay afloat. The low cost of debt has sustained what are colloquially called ‘zombie’ companies.

Of course, some businesses have struggled – Carillion is a prime example. The slow nature of our recovery from the global financial crisis has helped companies limp on at a stage in the cycle when we would expect debt to be more expensive. It’s safe to say that fewer businesses would have survived had we followed the usual course.

From an investor’s perspective, that makes matters much more unpredictable. At this point, we would expect to see an opportunity for good late-stage returns. In the prelude to these deals, share prices tend to jump – Sainsbury’s share price rose 14.5% in a day on the back of the Asda deal announcement.

That said, it could also precipitate moves into more defensive stocks. We could see more capital placed in cash-generative, less capital-intensive sectors, such as industrials, support services, and pharmaceuticals, as investors seek protection from a potential downturn.

These are unprecedented times. While it would take a brave person to make concrete predictions, it does seem that we’re going to see more volatility in the economy. And, just as Sainsbury’s and Asda have done, more companies look likely to go shopping in 2018 and into next year.

Stephen Martin is head of office at Brewin Dolphin Glasgow.