Does Wall Street Care About Economics?

It is a common occurrence that when a publicly traded company announces plans to acquire another publicly traded company the “value” of the acquiring company decreases, while the value of the company to be acquired increases. For example, when Oracle Corporation announced its proposed acquisition/hostile takeover of PeopleSoft, the value of Oracle’s stock steadily declined for the nearly 18 month battle while PeopleSoft stock rose $5.1 billion! This seems to occur in spite of whether investors and analysts believe the acquisition will be profitable to the expanded company or not. It is understandable why the public would invest in the company to be acquired- they will usually be paid a premium for their shares. What I question is why the public would believe the acquiring company is so much more worthless because it is venturing to expand. It seems that Wall Street must believe that the economies of scale have reached a saturation point. Of course, there are inherent risks when a large purchase is made. The integration may not be smooth, but in the long run why would the public believe that expansion is devaluing?


Dr. Tufte said...

This seems more like finance than ManEc, but that's OK (fortunately for me, I teach a little finance too). In the end, it comes back to something we've already discussed.

My answer is going to turn the title of the post around - Wall Street cares about economics but sometimes managers don't care enough.

The drop in the price of a potential acquirer is a reflection of the fact that most firms doing the buying do not do well after the acquisition. The lower prices follow from investors understanding of this. So, buying is a bad sign. Of what you might ask? The answer is that the acquirer has too much cash (which doesn't produce much income) and too few ideas (on where to invest that money to make more money). Generally, both of those are signs that management is too risk-averse. And it turns out that risk-aversion by managers is one facet of the principal-agent problem (owners committed to buying risky equity, if they had wanted less risk they could have bought debt ... but they didn't).

This is related to a disturbing outcome of some research in the finance literature - there is a consensus that a lot of management can be shown to be a net liability to the firm.

C-Dizzle said...

Perhaps the devaluing effect is caused by worried investors. The buying company is investing millions and sometimes billions of dollars in various cases that can be easily lost in such a takeover. It can be a major win-lose situation for any investor willing to hang in during the merger would it not?

On the other hand, the company to be bought out may have a large jump in the price of their stock. Investors may look at this merger in process and see that the company will greatly benefit from the merger. Many invest loads of money with high hopes of a large return in the “newly revived” or newly merged company.

(These opinions are given with a narrow view of the entire picture.)

Dr. Tufte said...

What happens typically is that the acquirer's stock price drops (suggesting this is a move that isn't appreciated by investors), and the acquiree's stock price rises (suggesting that investors recognize that the company is badly run, and have been waiting for someone to help improve it).

Karsten said...

Hello and welcome to the merry world of merger arbitrage!

When a merger is announced the price of the target's stock usually rises to a level just below the tender price (the gap depends on the percieved riskyness of the deal).

People who practice merger arbitrage seek to lock in the spread between the current market price and the level of the tender offer by buying the target's stock (thereby betting on the deal coming coming through and the gap narrowing). If the offer consists of a share component (share deal) the natural reaction is to hedge against any fall in the purchaser's share price by shorting an amount of the acquirer's stock equivilant to the exchange ratio. This will lead to the investor profiting from any convergence in the share prices of the two companies regardless of what the market does.

This makes for a very interesting (and crowded) relative value trade. The only real risk is to have the deal fall through - this will very nicely wreck your day :-)

Luise said...

The reason, as I recently learned in one of my many business classes, for mergers is that one company sees that another company is badly ran by its manager(s) so it wants to take it over and help the acquired company reach its potential. The reasoning behind the stock of the acquirer falling is as Dr. Tufte stated in both of his posted comments. It also seems to go like this; when we know someone has or wants something it makes whatever it is that much more appealing to us. And that is how it is!!!

homer said...

I think of Sears buying K-Mart. "K-Mart sucks", as we were told by Tom Cruise. Who would want to be a part of Sears after laching on to that cursed chain. Now Sears has made Wal-Mart their big competitor. . . . smart move.

Dr. Tufte said...

-1 on Homer's comment for a spelling mistake (waived).

I just thought I'd let you know that Karsten is a financial professional in Germany who reads this blog, and authors CurryBlog (in the list to the left).