A new narrative about today's stock market is starting to take hold on Wall Street.
It's a throwback to a time when many Wall Street titans had never even dreamed of investing — the 1960s conglomerate boom.
Here's how the story goes: Today's merger mania, which investors say looks a lot like what happened in the '60s, has been fueled by low interest rates and a "bigger is better" philosophy among CEOs.
This combination of factors has led to the creation of massive companies. Think: Valeant, Anheuser-Busch InBev, and Pfizer's potential acquisition of Allergan.
"We've seen periods when conglomeratization went too far, and one of the reasons you're seeing so many de-mergers, and split-ups, and so many activists are pushing for that, is we saw too much of that," Evercore Chairman Roger Altman said in an interview on CNBC on Monday. "Too many companies are just being big for the sheer sake of it. Too many CEOs thinking bigger is better. I think that has gone too far."
The same thing happened in the '60s. Back then the companies were Leasco and International Telephone and Telegraph (ITT) — the players were legendary investor Saul Steinberg and ITT CEO Harold Geneen.
They built massive companies through mergers and acquisitions much as is done today, but they had their worlds rocked when the market turned on them — when interest rates rose from 4% in 1963 to 8% in 1968. Earnings started to disappoint, stock prices fell, and all of a sudden companies couldn't close the acquisitions they needed to grow and maintain momentum.
That's when the music stopped.
"Top lines are weak, and therefore to get growth, synergies are appealing," Altman said in his interview.
"Mergers generate substantial synergies," he added, "so that provides for earnings and cash flow growth, even if it doesn't provide for revenue growth, and I think that's a big driver, so at the margin [this shows] weakness."
Presentation
The first we heard of this narrative was from a presentation at the James Grant Interest Rate Observer conference, when an investor named James Litinsky of the Chicago-based JHL Capital Group presented his slide deck, "Conglomerate Boom 2.0: A Stable Platform?"
Litinsky created an index of conglomerates from the 1960s, including Teledyne, Textron, and Ogden Corp., and charted their boom-and-bust cycle against the S&P 500's performance over the same period.
It looks like this:
Litinsky discussed the same factors, a merger mania fueled by low interest rates, aggressive CEOs, and investors hungry for earnings growth.
This sounds a lot like today's landscape. But the boom in the '60s ended with higher interest rates, lower earnings growth, and a sudden inability to do big deals. We know higher interest rates are coming, we've seen earnings growth slow, and soon companies won't be in an environment favorable to big deal-making.
Companies with a lot of debt in particular, such as the embattled drug company Valeant Pharmaceuticals, face a dark future.
Indeed, Valeant is on Litinsky's index of conglomerates poised to suffer from the market's changing environment. He calls this index The Platform Boom Index, and it includes the companies Anheuser-Busch InBev, Danaher, and Allergan Pharmaceuticals.
As with the companies in the 1960s conglomerate-boom index, these companies have outperformed the S&P 500 in a big way.
Valeant
Valeant's share price has been cut in half over the past month on accusations of fraudulent accounting and other nefarious activities perpetrated by Philidor Pharmacy, its once-secret distributor.
But some observers had decried Valeant's business model even before allegations of fraud threw the company into the spotlight.
One of them was short-seller Jim Chanos, who over a year ago said the company was an accounting roll-up. A roll-up is a company that does not grow organically but relies on serial acquisitions and aggressive accounting to show growth.
Charlie Munger, Warren Buffett's 91-year-old partner, said the same thing at an investor conference months ago. He compared Valeant to the 1960s conglomerate ITT.
"Valeant, the pharmaceutical company, is ITT come back to life," Munger told investors. "It wasn't moral the first time. And the second time, it's not better. And people are enthusiastic about it. I'm holding my nose."
In an interview with Bloomberg last week, Munger said Valeant created a "phony growth record" through "gamesmanship."
The problems with games, though, is that they all must come to an end, and someone eventually must lose.
