About advantages and disadvantages of mergers and acquisitions (M&A) and demergers

As a general rule, mergers and acquisitions (M&A) are value destructive for shareholders. Demergers or spin-offs are value accretive. In simple English, that means, avoid the shares of an acquiring company. But there may be money making opportunities in the companies being demerged or spun off.

There is a difference between a merger and an acquisition. Mergers are rare, as they happen between two companies that are equal in size and reach. Both companies lose their individual identities, and a third company is formed. For example, pharma companies Glaxo Wellcome merged with Smith Kline Beecham, and formed a third entity, Glaxo SmithKline.

In India, the situation was different. A much smaller but profitable and shareholder-friendly EsKayef lost its identity to the bigger but slower growing Glaxo. EsKayef shareholders were given Glaxo shares in the ratio of 1:2.

An acquisition, or a takeover, happens when a bigger company buys out a smaller company, with or without the smaller company's cooperation or willingness to be acquired. The usual motivations are economies of scale, killing a competitor, gaining market share and reach.

The biggest disadvantage of acquisitions is that they fail because of cultural mismatches. Every company is shaped over the years by the vision and background of its promoters or management. This is called 'company culture' - the way they project themselves in the market place, how they treat customers, employees, suppliers and shareholders, their social responsibilities, integrity and commitment, innovating capabilities.

No two companies do business the same way, even within the same sector. When one company acquires another, the cultural differences become very difficult to overcome. This leads to key personnel of the acquired company quitting and leaving with priceless intellectual property and customer relationships built up over many years.

Reverse takeovers, when a smaller company acquires a larger one, are even worse. Like Tata Steel buying Corus or Tata Motors buying Jaguar-Land Rover. In both cases, the the ambition was to become  global companies in quick time. But the prices paid in both cases were too high, and the timing was wrong. The shares of both companies tanked while they scrambled to raise money to cover the huge acquisition debt.

For shareholders of the company being acquired, an advantage could be a bidding war between two or more potential acquirers. This is currently happening with Great Offshore (earlier demerged from Great Eastern Shipping). Without any change in the fundamentals, the share price is going up as two likely acquirers are bidding up the offer price.

Opto Circuits is a notable example of an Indian company that has successfully used the acquisition route to grow its sales and profits quickly. Probably because they have shrewdly targetted companies with complementary products and geographical reach that were not doing well financially.

Demergers and spin-offs happen due to two main reasons:

1. Getting rid of an unwanted or less profitable division or subsidiary - like Larsen & Toubro did with its cement business, and ICI has done with its non-paint subsidiaries. Profitability and share prices of both companies increased significantly.

2. Spinning off a division or subsidiary into a stand-alone company because it has grown in size and value. Mahindra & Mahindra has done this a few times, with its financial services, information technology, holiday resorts subsidiaries.

Investors would do well to look out for companies that have 'hidden assets' in the form of profitable subsidiaries. Sooner or later, these subsidiaries will get demerged or spun off. With reforms in the financial sector a top priority of the Government, I would keep a close watch on companies with asset management (read, 'Mutual Funds') and insurance subsidiaries.

A few companies that come to mind are Reliance Capital (though I'm not particularly fond of the word 'Reliance'), Exide, HDFC, Sundaram Finance, SBI, Canara Bank.

(Interested readers can learn more about M&A from this article.)

Which sectors should you invest in?

In an earlier post ("Market Cycles and Sectors") on Dec 1, 2008 the sectors that receive prominence during different stages of the economic and stock market cycles were discussed.

Does that mean that you, as a small investor, should look at investing in all those sectors? Probably not.

Fund managers, who are under pressure to perform in the short term, have no alternative but to move in and out of sectors depending on the particular stage of the stock market. They also have access to company managements and better research resources and larger funds than small investors.

With considerably less funds and little or no research capabilities, small investors like you and me are better off choosing only a handful of sectors to invest in.

Some industries are in an environment that helps to create substantial competitive advantage. It is easier for the companies in such industries to make money.

Four sectors that I like - based on their competitive advantage and cash generation capabilities - are :-

1.  FMCG: Strong brands built up over the years create huge competitive advantage. Companies tend to be solidly profitable, debt free and generate a ton of cash (which is distributed to investors through generous dividends). The market leaders have been around for many years, so they are slow but steady performers.

This sector is practically recession proof and should form a significant part of a small investor's core portfolio. Companies to look at are HUL, ITC, Colgate, Nestle, Brittania, Dabur, Marico.

2.  Pharmaceuticals: Like FMCG, Pharma companies are recession proof, have strong brands, are hugely profitable and good dividend payers, and long term growth is assured because of the large population. MNC Pharma companies have access to better product pipeline from their overseas parents. Domestic Pharma companies profit from generics and contract research and manufacturing.

This sector should also receive pride of place in your portfolio. Companies to look at are Glaxo Pharma, Aventis, Sun Pharma, Lupin, Glenmark.

3.  Financial Services: Banks pay less interest to depositors and lend the money at higher interests. For current account holders, banks pay nothing at all. Many make more money by selling other financial products to their customer base - such as insurance, demat accounts, credit cards, mutual funds, home loans. Home loan companies tend to be highly profitable with long term growth assured.

Companies to look at are State Bank of India, Bank of India, HDFC Bank, Axis Bank, HDFC, LIC Housing Finance, Sundaram Finance.

4.  Media: Many companies have competitive advantage through regional language and regional market domination. This sector also tends to be recession proof.

The dynamics of the media business was covered in an earlier blog post on Sept. 8, 2008.

Are these the only sectors that an investor should look at? Obviously not. But this should be a good starting point in building a long term portfolio.

Future posts will cover other sectors and criteria for individual stock selection.

Your portfolio of stocks and mutual funds - why you shouldn't diversify

Investment analysts and the pink papers cry themselves hoarse about why investors must diversify their portfolios to mitigate risk and enhance returns.

This is another one of those investment myths that need debunking. Peter Lynch coined the term di'worse'ify about companies who enter unrelated areas of activities. The term applies equally well  for investors.

50 stocks or 20 funds in the portfolio is a classic case of di'worse'ification. Individual investors should try not to have more than 10 stocks or 5 funds in their portfolio. Otherwise it takes too much time and energy to keep track of the performance of individual shares and funds.

The richest individuals in the world tend to have extremely concentrated portfolios. Think about Microsoft's Bill Gates, Oracle's Larry Ellison, Walmart's Sam Walton, Infosys' Narayanmurthy.

While the average investor like you or me can't be compared with the legends mentioned, we can reduce risk and enhance wealth by placing a few concentrated bets on outstanding stocks. The key word here is 'outstanding'.

If you prefer particular sectors, avoid sugar or cement or real estate that give you windfall profits one day and huge losses on another. Concentrate on defensive sectors like FMCG and Pharma. You'll get steady and regular returns through price appreciation and dividends. And the downside will be limited.

So here is a formula for investment success. Buy a few outstanding stocks from the FMCG and Pharma packs - like Colgate, Hind Lever, ITC, Nestle, Glaxo, Lupin, Sun Pharma. These will provide steady returns and limit your losses during bear markets.

Balance such a sector tilt with stalwarts like Reliance, L&T, Bharti, Tata Steel, M&M. For a little extra, albeit risky, return add the odd Maharashtra Seamless and Opto Circuit.

Mutual Fund investors can buy a couple of diversified equity funds (like HSBC Equity, DSPML Top 100, Sundaram Select Focus), a couple of Balanced Funds (like HDFC Prudence, DSPML Balance) and an ELSS fund (like Magnum Tax Gain or Sundaram Tax Saver).

If you feel that such a portfolio is boring or uninteresting, then that is a very good indicator that you will make very good returns! For excitement and adrenaline flow, you can always visit Las Vegas or the Mahalaxmi race course!