A new narrative about today’s stock market is starting to take hold on Wall Street.
It’s a throwback to a time when many Wall Street titans had never even dreamed of investing — the 1960s conglomerate boom.
Here’s how the story goes: Today’s merger mania — which investors say looks a lot like what happened in the 60s — has been fuelled by low interest rates and a ‘bigger is better’ philosophy among CEOs.
This combination of factors has led to the creation of massive companies. Think: Valeant, Anheuser-Busch InBev, and Pfizer’s potential acquisition of Allergan.
“We’ve seen periods when conglomeratization went too far, and one of the reasons you’re seeing so many de-mergers, and split-ups, and so many activists are pushing for that, is we saw too much of that,” Evercore ISI CEO Roger Altman said in an interview on CNBC on Monday. “Too many companies are just being big for the sheer sake of it. Too many CEOs thinking bigger is better. I think that has gone too far.”
The same thing happened in the ’60s. Back then the companies were Leasco and International Telephone and Telegraph (ITT) — the players were legendary investor Saul Steinberg and ITT CEO Harold Geneen.
They built massive companies through M&A much like today, but had their worlds rocked when the market turned on them — when interest rates rose from 4% in 1963 to 8% in 1968. Earnings started to disappoint, stock prices fell, and all of a sudden companies couldn’t close the acquisitions they needed to grow and maintain momentum.
That’s when the music stopped.
“Top lines are weak and therefore to get growth, synergies are appealing,” Altman said in his interview. “…mergers generate substantial synergies so that provides for earnings and cash flow growth, even if it doesn’t provide for revenue growth and I think that’s a big driver, so at the margin, [this shows] weakness.”
The first we heard of this narrative was from a presentation at the James Grant Interest Rate Observer Conference, when an investor names James Litinsky of Chicago-based JHL Capital Group presented his slide deck, ‘Conglomerate Boom 2.0: A Stable Platform?’
Litinsky created an index of conglomerates from the 1960s — Teledyne, Textron, Ogden Corp and more — and charted their boom and bust cycle against the S&P 500’s performance over the same period.
It looks like this:
Litinsky discussed the same factors — a merger mania fuelled by low interest rates, aggressive CEOs and investors hungry for earnings growth.
This sounds a lot like today. It all ended with higher interest rates, lower earnings growth, and a sudden inability to do big deals. We know that higher interest rates are coming, we’ve seen earnings growth slow, and soon companies won’t be in an environment favourable to big deal making.
Especially those with a lot of debt, like embattled drug company Valeant Pharmaceuticals, face a dark future.
Indeed, Valeant is on Litinsky’s index of conglomerates poised to suffer from the market’s changing environment. He calls this index The Platform Boom Index, and it includes companies Anheuser-Busch InBev, Danaher and Allergan Pharmaceuticals.
Just like the companies in the 1960s conglomerate boom index, these companies have outperformed the S&P 500 in a big way.
Over the last month Valeant’s share price has been cut in half on accusations of fraudulent accounting and other nefarious activities perpetrated by its once-secret distributor, Philidor Pharmacy.
But there were some that decried its business model even before allegations of fraud threw the company into the spotlight.
One of them was short-seller Jim Chanos, who over a year ago said the company was an accounting roll-up. A roll up is a company that does not grow organically, but relies on serial acquisitions and aggressive accounting to show growth.
Charlie Munger, Warren Buffett’s 91 year-old partner, said the same thing at an investor conference months ago. He compared Valeant to 1960s conglomerate ITT, which made money in an “evil way.”
“Valeant, the pharmaceutical company, is ITT come back to life,” Munger said to investors. “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.”
In an interview with Bloomberg last week, Munger said created a “phony growth record” through “gamesmanship.”
The problems with games, though, is that they all must come to an end, and someone eventually must lose.
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