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The Incredible Shrinking Market

By Ari Charney on October 28, 2016

Even when interest rates finally return to normal, there’s an aspect of this extended run of historically low rates that could have lasting repercussions for income investors.

And it also happens to be one of the consequences of the Fed’s easy-money policies that rarely gets criticized: sweeping consolidation.

With organic growth hard to come by in this underwhelming recovery, companies across all sectors have used dirt-cheap debt to buy new growth.

And every time the Fed makes noise about further monetary tightening, companies rush to get one more big deal done before the cost of money goes up.

Over the past five years, there have been $8.0 trillion worth of mergers and acquisitions (M&A) in the U.S.

By contrast, during the five-year period that preceded the Global Financial Crisis, there were $5.9 trillion worth of M&A.

2016-10-28-U&I-Total M&A

That shows the power of dirt-cheap debt to boost M&A—in this case, by nearly 36%.

Of course, if you’re lucky enough to own a takeover target, you stand to pocket a fat premium. At Investing Daily’s Utility Forecaster, for instance, we’ve enjoyed premiums as high as 45% over the past year as some of our favorite companies got acquired.

And in a few cases, acquisitions were announced just months after we added these companies to our portfolios. That feels good because when another company is willing to pay top dollar for one of our holdings it vindicates our approach to stock selection.

At the same time, it also creates what we like to refer to as the happy dilemma.

As income investors, we’re accustomed to the sort of slow-and-steady growth that underpins a rising dividend. Of course, we’re also happy to take a big capital gain when we can get it.

But every time one of our dependable dividend payers gets taken out, it means we have to go out and find another reliable stream of income to replace it.

Therein lies the rub of eight years of short-term interest rates hovering just above 0%: The resulting industry consolidation is reducing the number of dividend stocks.

Longtime utility investors know that the number of publicly traded electric utilities has essentially halved over the past 20 years. Now it’s getting even smaller.

Similarly, there are just nine publicly traded U.S. water utilities. And there are really only seven investable pure-play gas utilities left.

At the sector level, of course, there are other factors that drive consolidation beyond a low cost of capital. Although the current utility sector consolidation is impressive, it hasn’t quite reached the dizzying heights of 2007.

2016-10-28-U&I-Ute M&A

Back then, the sector was emerging from a disastrous experience with deregulation. Sector wipe-outs can actually lead to a wave of consolidation.

This time around, electric utilities are contending with weak demand growth and the cost of complying with regulatory momentum toward renewables. That’s prompting utility giants to seek growing streams of regulated earnings.

Some utilities are acquiring peers that operate in service territories supported by a robust economy. Others are picking up gas utilities with hopes that the shift toward cleaner energy will lead to secular demand growth for natural gas and the infrastructure that delivers it.

There’s also consolidation in other sectors known for dividend payers, including consumer non-discretionary stocks, a sector that includes food and tobacco stocks, as well as healthcare companies, among others. As the chart below shows, M&A volume over the past three years has spiked compared to the last cycle.

2016-10-28-U&I-Consumer M&A

Nevertheless, one could argue that while the pool of dividend payers is shrinking, consolidation could help spur greater dividend growth in the merged entities as synergies are realized and new platforms for growth are backed by ample capital. At least, that’s the line that company management teams try to sell.

Still, we prefer being able to fine-tune our exposure to certain areas of the market, which becomes more difficult when there are fewer names from which to choose. After all, greater portfolio concentration can lead to greater risk.

But it’s important to remember that M&A goes in cycles, and the current trend toward consolidation could eventually reverse.

Sometimes the rationale for combinations can prove wrong and companies will make divestitures. Other times, investors can demand spinoffs of business units to unlock greater shareholder value.

However, these are trends that can take a decade or longer to play out. In the meantime, the pool of dividend stocks is getting smaller.


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