Shell's proposed takeover of BG Group is an indication that the bull market is getting long in the tooth, but that doesn't mean it's time to worry.
Shell's $70 billion offer for rival BG Group is significant for a variety of reasons, not least of which is its size – if it goes through it will be the biggest energy company deal in more than a decade. However, more interesting for economic observers is what it says about where we are in the cycle, and in this case it clearly shows we're in the later stages of a bull market (the later stages can go on for 18-24 months).
The economic uncertainty of recent times has overshadowed just how well markets have performed, with the FTSE 100 Index doubling since its nadir in 2009. Irrespective of what Shell is up to, it's clear that equities cannot continue to increase in price indefinitely. We also have other indicators that markets may be close to turning:
- Company margins – the difference in what they are earning and paying out in costs – are at historically high levels, due mostly to corporations reducing costs in recent years rather seeing sales grow (not surprising when we've been in the economic doldrums for so long).
- The labour market is getting healthier, which should eventually lead to wage inflation, which in turn will hurt company earnings.
Shell's eagerness to undertake such a massive transaction will be driven by multiple factors. Significant among these are the high margins, which leave little room to expand profits internally and instead mean that one of the few ways for companies to grow earnings is through taking on another business. With this deal, Shell becomes the dominant player in the liquefied natural gas (LNG) market, and also becomes the largest foreign energy company operating in Brazil.
Its core focus will then be to remove duplicated overheads across the new expanded business. But the structure of these businesses means extracting overheads can be difficult – when you acquire an additional oil well, you still need a team of engineers to maintain that facility, and it will not be economic for your team on the other side of the world to take on this additional task. Thus, the $2.5 billion of proposed cost savings are pretty insignificant when compared to the $70 billion price (a chunky 50% premium to BG Group's three-month average). The increased debt burden as a result of the purchase (its gearing will increase from 12% to 20% should the transaction proceed) demonstrates a confidence that executives start to show when good times have been going on for a relatively long time. The risks of the deal – the company may face a competition challenge from its new-found stature in the LNG market, while the increased debt could threaten Shell's ability to maintain its dividend – also make this a costly acquisition.
Large, poor value deals tend to demonstrate a certain inflated confidence in the market that in the past had preceded a pullback in share prices – M&A activity so far this year is at its highest level since 2007, just before the financial crisis engulfed the world. But even with executive hubris indicating a change in market fortunes, a shift in the cycle is no more something to fear than the change from season to season. It's natural that stocks tend to go through periods of growth, and then pull back as realism is injected into the over-optimistic projections endemic in giddy markets. To try and time gains and falls in markets by jumping in and out of equities is impossible to get right.
Our response as pragmatic investors is to do what we always do, which is to seek those investments that are the best value, and can protect against declines in the general market by retaining potential for growth. That's why we reduced our exposure to US equities, which are looking particularly expensive at present, but have increased holdings of some UK, European and Japanese equities, where we still see some value. The fact that a market turnaround may not come for more than a year means that we still want to capture as much upside as possible of continuing growth. But we also want to be better prepared for any change in market conditions when that comes, and Shell's massive takeover plan shows that it could be coming sooner rather than later.
This content was generated prior to Turcan Connell Asset Management Limited operating as Tcam.