Assessing the impact of increasingly stock-focused management teams on company performance.
As investors continue to debate which regional market offers the best expected equity returns, we believe that European shares could benefit from several potential tailwinds. This article looks at two of these, namely the improving attitude of corporates towards buybacks and a reignited appetite for M&A activity.
Traditionally, CEOs of leading US firms have focused more pointedly on shareholder returns than their European peers. They’re incentivised to do so: 80% of US companies link CEO compensation to some share price-related metric1. In Europe, the numbers have historically been much lower, but although they currently range from as low as 15% in Spain to around 50% in France2, the trend is definitively upwards. It’s one of a suite of factors that persuade us that increasingly share price-focused management teams in Europe are going to be important drivers of performance in the coming months and years.
Morgan Stanley recently released a piece of research which made a case for European equity outperformance, based not only on the widely expected foreign capital inflows, but also on share buybacks. It’s a compelling argument, supported by data from EPFR3, and chimes nicely with the idea that European CEOs are finally being encouraged – contractually and by activist investors – to pay greater attention to the interests of their shareholders.
Certainly the CHF20bn Nestle share repurchase that was announced at the end of June4 gives cause for investors to focus again on buybacks as an additional tool to boost earnings growth in Europe. In that case, some may speculate that management’s hand was forced by pressure from activist investors, but even without such direct encouragement, we believe it is likely that corporations will increasingly employ buybacks in Europe over the coming quarters. In a note entitled ‘Time to Buy(Back)?’, Goldman Sachs listed a host of factors supportive of buyback activity, including the CEO pay structures we mentioned before, increased cash flows, the cheap cost of credit and more solid balance sheets. They also cited a reduction in political risk since the French elections earlier this summer. On top of these dynamics, we do not believe that the euro is going anywhere in the near term – and thus company management teams are finding the cash buffers they hold in case of another crisis increasingly difficult to justify.
What is clear to us is that, for cultural and historical reasons, European corporations haven’t used buybacks anything like as enthusiastically as their US peers. Since 2009, buybacks have accounted for a quarter of cumulative EPS growth in the US, while in Europe the equity gap (capital increases minus buybacks) had a negative impact on EPS. US corporations used 23% of their cash balances in 2016 for buybacks, while in Europe the figure was 5%5. Figure 1 is striking evidence of the untapped potential that exists for European buybacks.
Figure 1. Stoxx Europe 600 ex-Financials buybacks level versus S&P 500
Source: FactSet, Goldman Sachs Global Investment Research.
It’s worth considering the substantial contribution that buyback activity makes to US EPS growth. Without this turbo-charging of returns, US EPS growth over the past two years would actually have been negative. European companies, on the other hand, are growing their earnings organically, and there exists potential for accelerating this further via buybacks. What’s more, those companies that have carried out buybacks in Europe have seen marked outperformance (38% versus their peers in the past five years6). And it may be that we’re already moving towards an inflection point. As Figure 2 shows, the equity gap is beginning to close in Europe as we see fewer large rights issues and more M&A and buyback activity.
Figure 2. Equity supply gap starts to close – percentage of market cap increase/decrease in net equity supply per year
Source: Datastream, Goldman Sachs Global Investment Research, 5 July 2017. Note: Equity supply is the change in market cap not accounted for by price.
Let’s turn now to another potential driver of returns in Europe – M&A activity. Europe is a notable outlier in terms of global M&A action so far this year. The value of deals targeting European firms rose 18% in the first half of 2017 (after a strong second half to 2016) versus the US, which saw a drop in activity of 13%7. Importantly, Europe is still running at around 50% of its 2006-7 peak, while the US has already surpassed those highs. We believe this is another powerful indicator of as-yet-untapped potential in the European markets.
It’s important also to look at who is driving the current M&A activity in Europe, with 25% coming from private equity deals, a potential sign that opportunistic investors are increasingly seeing value in European assets8. Large cross-border deals will always attract regulatory scrutiny in Europe, and recent headlines suggest potential further measures by the European Commission to enhance control9,but while many would hold up the apparent failure of Kraft Heinz’s bold approach to Unilever, or PPG walking away from its attempts to buy Akzo Nobel, a balanced view would also acknowledge Johnson & Johnson’s purchase of Actelion and the USD43bn tie-up between Syngenta and ChemChina. Beyond regulation, we find that these types of deals often depend on how committed the acquirer is to the transaction. History has shown us that with wholehearted conviction, even century-old companies can adapt their approach to take more shareholder-friendly action.
This point brings us back to buybacks and motivated management teams. Because a pick-up in M&A activity will necessarily focus management teams on protecting themselves from aggressive acquirers, or at least on ensuring the best possible deal for their shareholders. With activist investors circling and private equity driving more deals than ever, the European landscape is changing. We believe that those management teams that do not recognize this and respond accordingly could find themselves left on the sidelines.
1. Source: Goldman Sachs Portfolio Strategy Research, ‘Strategy Matters: Time to buy(back)?’, 5 July 2017.
3. EPFR, FactSet, Bloomberg, Morgan Stanley Research, 13 July 2017.
4. Source: Bloomberg, 27 June 2017. Full article here
5. Source: Goldman Sachs Portfolio Strategy Research, 5 July 2017.
6. Source: Morgan Stanley Research, 13 July 2017.
7. Source: Morgan Stanley Research, 30 June 2017.
9. Cited in media publications including the FT, 13 August 2017: 'Brussels seeks tighter vetting of foreign takeovers’.