The impact of acquisitions on stock returns

Sometimes, I come across an academic study that was supposed to investigate something else entirely, yet the message I take away is something different altogether. This happened to me when I read an NBER Working Paper on the link between management quality and multinational expansion of businesses.

The paper by José Fillat and Stefania Garetto makes the point that businesses run by better managers tend to expand internationally. Even when these firms are smaller and purely domestic, they already have a larger risk premium than purely domestic companies that stay domestic afterwards.

It doesn’t surprise me that higher quality management is linked to international expansion. I would have thought that companies run by better managers grow faster and are more profitable, so they have more cash to spend on acquisitions. And eventually, they will outgrow their home market and become multinational enterprises (MNEs).

But where I stumbled was the part of the note that said that multinational companies have a larger risk premium than purely domestic companies. Shouldn’t purely domestic companies have a higher risk premium because they do not have an internationally diversified revenue stream? And shouldn’t domestic companies have a higher risk premium if they are, on average, run by worse management teams?

Then I read through the paper and realised that by risk premium they truly mean a valuation premium. Companies with better management and an international footprint trade at higher multiples. But that, in turn, means that the actual shareholder return should be lower for these companies. And indeed, that is the case. The chart below shows the average return of US companies when adjusted for the size, value, and market factors.

Annualised return of US companies by revenue and acquisition strategy

US companies that remain domestically oriented and companies that are multinationals but don’t make any acquisitions tend to have higher returns than companies that make acquisitions. And when comparing companies within each group, domestically oriented companies tend to have higher returns than MNEs.

What the paper shows is that even though companies that are run by better management teams eventually expand more. And this expansion through acquisition destroys shareholder value on average. Detailed analysis of the share price reaction to acquisitions confirms this for both domestic and international firms. So, be careful when you are investing in companies that are embarking on a strategy of acquiring many competitors. With some companies, it works, but on average, this is not going to end well for shareholders.

The fact that, between domestic companies and multinationals, domestic companies tend to have higher returns on average points to the fact that multinationals are run by better management teams and, on average, have higher profitability and more diversified revenue streams. This makes purely domestically-oriented companies riskier, and this risk seems to be compensated with higher returns over the cycle.

Given that UK domestic companies have performed so poorly in recent years when the UK economy has lagged the US and other markets, this may come as some comfort to investors in these companies.

But here is another bit of information from the paper that I found interesting. It shows where US companies go to shop. UK businesses are the prime targets for US companies looking to expand internationally. Is it any wonder the number of listed companies in the UK is shrinking all the time?

Acquisition targets of US companies