Takeover obsession dangerous with profits nearing a peak

Stock markets have become dangerously obsessed by takeover deals when global profitability may be nearing a peak, according to Resolution Asset Management.

James Smith, chief investment officer of specialist funds, is concerned that markets may be eschewing fundamental stock analysis in their efforts to identify companies which may become subject to a takeover approach.

Although he believes that multiples have been justified by economic growth, he questions how much further profits can rise from current levels, arguing that an imminent short correction might be beneficial to markets’ longer term prospects.

He says: “The current situation reminds me of the UK market in 1986, when everyone had to own the next big takeover candidate. Like then, the market is being led by the takeover theme. The question is: how much further can profits rise? We’ve seen some economic slowdown in the US already – there is no guarantee that it won’t get worse.”

Smith is particularly concerned about the role of private equity firms in the clamour for takeover targets. He believes lenders’ current generosity towards private equity – chiefly in terms of their willingness to offer ‘covenant-lite’ loans – is a worrying trend, although he believes the potential problems could apply to all acquisitive firms.

He says: “Credit seems to be very cheap to the private equity firms. The tail is wagging the dog. One of the more concerning aspects now is that it is not just the poorly-run firms which are being taken over – it is also the good firms with little scope for restructuring. You wonder where the private equity firms are going to squeeze the extra profits from.”