Today's M&A Environment: How Long Will It Last?

All right, before I introduce, uh, introduce, uh, Jeff, uh, I just would like to again publicly thank all of our sponsors, uh, for your assistance in putting on this conference. Uh, without your support and without your help, uh, this conference wouldn't have been as successful as it was. So thank you again, I appreciate it, and I know, uh, AMA appreciates it as well. So I'm here to introduce Jeff Mortimer. Jeff is the Director of Investment Strategy for BNY Mellon Wealth Management. In this role, he leads a team that sets capital market expectations and is responsible for making asset allocation recommendations. Jeff has more than 25 years of experience in the financial services industry. Prior to joining the firm, Jeff worked for Charles Schwab for 13 years in increasingly senior positions, culminating with his appointment as Chief Investment Officer. Jeff received a Bachelor of Science degree in Finance from Babson College and a Master of Business Administration from the University of Chicago Graduate School of Business. So without further ado, please join me in welcoming Jeff.

Thank you very much. I'm a walker, so I'll probably— I'll walk around the stage, maybe jump down to your level. I'm Italian, I have to use my arms or I can't really speak, so it's a trait of mine. You might be asking yourselves, what is an asset allocator doing at an M&A conference? And if I were you, I'd be asking myself the exact same question. So let me get into— I am within our firm, I call myself the "so what" guy. I'm not an economist by training. I'm a money manager. And I was hired 3 years ago in this role after interviewing with 18 people because they wanted to understand how I would change asset allocation around a business cycle. And what they didn't know at the time was that I've actually quantified business cycles going back some 50 years. And because I've quantified them in such detail, I'm able to overlay any set of data onto the business cycle and to determine sort of when things happen, when they peak, when they trough, when they're gaining share and when they're losing share. And so what I'd like to do today is take you through not sort of my economic outlook because, you know, talk is cheap, but instead I'd like to show you my methodology for how I look at business cycles and then overlay on top of that M&A cycles. And as you advise business owners, you can talk to them probably in a different language because I have no axe to grind. Investment bankers, of course, always want business owners to sell because that's how they make fees. But for me, I look at the world through the public markets and what are they signaling to business owners and multiples, when should one sell one's business and when should potentially one hold off. You know, it's interesting that I am, of course, trying to look into the future. It's a very difficult thing to do. You know, Yogi Bear, I think, had the best quote: "Predicting is really hard, especially when it's about the future." But I have learned that the farther that you can look back, usually a lot of times, the farther you can look ahead. But sometimes even looking ahead isn't enough. So I'm going to ask each of you, let's go back mentally to June 2008. Okay, so go back 7 years and think about a prediction— predictions back then that we would enter a financial crisis, that we would eventually recover from it but have a subpar recovery from that in the US. The eurozone would be going through amazing issues in the next 7 years, culminating with the potential for one of its members to be leaving and defaulting on their debt. The Middle East would still be in turmoil with new groups such as ISIS sort of forming, Iran being more and more powerful as a nuclear power. Russia would invade the Ukraine, annex Crimea. So, I mean, let's just talk about all these geopolitical issues that would be going on. And then how many of you would say that the market under that whole backdrop would be near all-time highs? 7 years later? I bet no one in the room would sort of raise their hand, and also that M&A activity would be as strong as it is under that backdrop. So even if you can predict going forward, it doesn't necessarily mean that you would give the proper advice, because a lot of times how markets react are very different than what the outcomes are. So what I want to do is present to you kind of my thinking process, my thought process for how we position client assets through that turmoil and also again, then tie it back to your world in M&A activity. So what you see to my right is the basic economic cycle. A trough is at the bottom, expansion's up the left-hand side, a peak is at the top of the page, and contraction is down the right-hand side. These are economic markers in general for what you should be paying most attention to depending on where you are in a cycle. So at a market trough, you really must be paying attention to the unemployment rate. All other factors mentioned on CNBC in other channels. And I am part of the problem. I've been on CNBC over 100 times. By the way, the price of admission to get on TV is 3 stock picks and how the market will trade for the next 90 minutes. Okay, that time, I am not kidding. Maria Bartiromo asked me at 2:30 Eastern in the afternoon, Jeff, how do we trade into the close? I'm looking at her like, wow, that's amazing. We're now down to 90-minute trading, right? That's what's important to us now as investors. It's incredible how our time horizons have shortened. At market troughs, the unemployment rate is the most important thing because it will change direction. It's a lagging indicator, but it's deadly accurate in its ability to tell you economic direction. From there, commodity prices rise. They, to me, are the canary in the coal mine, and they all rise together as the global economic engine begins to catch gear. Inventories decline, profits accelerate. M&A activity then begins to take place as capital expenditures, IPOs, all these things are mid to late cycle phenomenon. Enter now from stage left, our bull market killers: rising inflation and rising interest rates. We have to understand that bull markets in this country tend not to die deaths of natural causes. They don't. They are most of the time murdered by our Fed on purpose to combat inflation, typically. And you can see low unemployment sits at the top of the page. It is a wonderful marker for an economy that is overheating, for an economy that doesn't have a lot of slack in it. Business owners that you're consulting to are having a hard time finding and keeping people and have to pay them more and more money to do so. So low unemployment, while Main Street loves it, Wall Street does not. And then you have symmetry. So what was rising commodity prices at 7 o'clock on this wheel is now falling commodity prices up at 1. So 7 becomes 1, 8 becomes 2, 9 becomes 3. They're just in reverse. And there you have a basic economic cycle, but in a way I hope that you haven't seen before, because it's telling you what economic markers you should be paying most attention to depending on where you are in the cycle itself. Human emotion is then overlaid. We're all professionals kind of in this room. I would spend a lot of time here, but the human being is wired in certain ways. And we are wired, actually, to survive in the woods. We're very good at that. Still, even in the year 2015, we're still wired to survive in the woods. We are not wired, however, to be good investors. And if we let our emotions make our investment decisions, usually we're wrong. 5, 6 of the time, we are wrong. And I'll show you kind of why that is in a minute. We're fearful at market bottoms, and when we're fearful, we tend to sell stuff at fire-sale prices. That's our human emotion. Or it's a margin call, either one. And business owners are not exempt from this fear either. They can do irrational things at irrational times. From fear, we sell, right? In the public markets, we're selling equities. Then the human emotion goes on to do something else. As fear dissipates because markets rally off their bottom, doubt and disgust now kick in like a German train schedule. We're disgusted that we sold our stocks at the bottom, but we doubt that the rally is real because Maria Bartiromo just came on TV and told me that it was a dead cat bounce. So, I don't have to buy back yet because it will come back down to the level that I sold. If I want to get back in then, I can. Wall of worry is overused on Wall Street. Here you see it black and white. By the way, this chart was created by me in my office in San Francisco in 2002. 2002. 13 years old now, not a word has changed on this page. It didn't know about the financial crisis, it didn't know about the bull market of 2003 to 2007. So it just sort of sits here. Wall of worry, overused on Wall Street, but it's between 8:30 and 9:30. All bull markets climb them. If you give the market bad news during this period of time, it goes up anyway. If you give the market good news, it goes up a lot. I love that same outcome regardless of news. So 9 o'clocks, to me, these are wonderful times. To be an investor in the public markets. Greed kicks in 5 hours after fear. In real time, it's about 5 years, 4 to 5 years, and markets have gone up between 100 and 150% without us in them emotionally. Euphoria is the opposite of fear, and it sits at the top of this chart because euphoria measures a buyer who is indiscriminate on price. Just like a fearful seller is indiscriminate on price and just wants the stocks or his company out of his portfolio, a euphoric buyer is also indiscriminate on price. And I always learned, boy, when somebody's willing to pay anything for something, I need to sell mine to them, right? That's the time when I should have a methodology which removes emotion, gets much more practical, and starts laying off assets to the people who are willing to pay any price. The euphoric buyer runs into issues. As the human emotion kicks in, which next is wishing and hoping. The euphoric buyer typically pays too high a price, say $100 a share in the public markets, or for a company, whatever the case may be, $100 million. And then quickly the asset falls in value, and they wish and hope that it would go back to their original cost basis. And they make a deal with themselves, especially in the public markets, and that is that they will sell it. They will sell it if they can get back to cost and just remove it from their portfolio. But of course, as I've taught you now, the wheel does not move backwards. It continues to only move forward. So, wishing and hoping, if that is what you look when you see in your portfolio, that's your emotion, you're wishing and hoping that your assets would appreciate back to your cost value. Understand that that's the most dangerous emotion that you can have. Because wishing and hoping leads to self-loathing as the public stock falls to $50, misery as it falls to $20, and then fear and pessimism as the stock falls to $10. That was names even like Amazon.com, which went from $100 a share down to 10 during the tech bubble and burst of 1999 into 2003. So that's the human emotion. That's what we wrestle with, with our clients. And business owners, of course, face these same issues. The proper mindset is in the innermost circle, and this is where the best investors live, the best decision-makers. At 6 o'clock, one should be a contrarian. A lot easier said than done. I'm also sick and tired of newscasters saying after the market rallies 50% off its bottom, they say that the easy money has been made. To me, a great— right, that is the misstatement of a lifetime. To step in when all others are fearful and to buy instead, it takes incredible chutzpah, incredible risk. You won't feel very bright doing it. You'll feel like you're making a mistake, but it is, right, it is a contrarian mindset that tends to win. Positive bias as you climb a wall of worry. I talked about that one. Mid-cycle bull markets tend to climb this. You can be aggressive in your portfolio in late-cycle bull markets. You can be aggressive. You can add beta. You can add risk to the portfolio. You can add growth stocks to the portfolio. And greed is what we're doing without effort. So this is the only part of the wheel when what we're feeling emotionally and what we should actually be doing, they line up. And that's why I mentioned to you, 5/6 of the time, if you use your emotion, you're making the wrong investment decision. Only between 10 and 12 does it become easier to be an investor because our emotions are leading us to the proper answer. But the euphoric buyer then runs into a prudent seller. The prudent seller, of course, makes all the money. And finally, you can see here that bear markets take place in either one or two stages. The prudent stage, as I call it, which is 12 to 3, and then there's a capital preservation stage. Bear markets tend not to begin brutally but if they are dual stage, they end brutally. The worst part on this wheel is 3 to 6. Markets go down sharply, 12 to— 6 to 12 months in length, 20 to 30% negative returns in the S&P if you do get a 3 o'clock signal that leads you to 6. So, what does all this have to do with M&A? Because this is just what happens sort of in the public markets and how human beings respond to them. So what I was able to do, as you heard in the introduction, I'm deeply quantitative. MBA from Chicago, I'm a CFA. If you go to my office in Boston, it's actually all numbers, right? Well, I worked a little bit on this color scheme because I wanted it to look pretty. Understand that there are 4 models that go underneath this instrument. And what I've done going back to 1969, as I mentioned in my introductory messaging, is that I've mapped every 6 o'clock going back 50 years. I've mapped every 7, I've mapped every 9, every 10, every 12, and every 3. And because I've mapped them like that, I can lay any sorts of data, including what happens in the private markets, right? When do multiples peak for private transactions? What is the public— at what time in the public markets should a business owner think about selling his or her business? What can our capital markets that are publicly traded, open information to anyone, what can they signal to business owners? So what I've done here is I've overlaid small business sort of advice or business people advice. And what you see in the red lettering is when a business owner should look to sell one's business. And it is actually at 10 o'clock at a late cycle bull market. And the punchline of today's presentation is that is where we sit today. We actually entered 10 o'clock. 10 o'clock signal was given by this methodology. And if I taught my 12-year-old son these same rules, he would also know what time it is. Okay, so complete rigor. It took me 15, 16 years to do this work. We sit in a late cycle bull market. We've been there since July of 2013, July 31st to be specific, of 2013. And I've talked to a lot of investment banks and presented the same type of material to them, and they said, how did you know that? How did you know that my business started to pick up and that multiples have been expanding in the private business, right, ownerships, and that transactions and liquidity events have picked up really since that time? And I said, because that's when they always pick up. So let's look again, protect one's business. If you do get to 12 o'clock, a small business owner should look to protect, not expand, not hire, not take on debt, leverage, anything like that, not merge. Protection is the name of the game as you enter late cycle or as you begin early cycle bear markets. And only down at 6 and 7 o'clock do you then borrow, build, acquire others, or let nature take its course. And those that did not protect, let them go out of business by themselves. So we sit today at 10, and I wanted to show you what 10 o'clock— what does this mean? How long do they last? If you're giving advice to a small business owner, how long will the window to sell one's business stay open? So what I've done is I've mapped every 10 o'clock going back to 1969. The left-hand side of the page looks at how long do they last. And by the way, all 10 o'clocks, they have a downside to them. They all end at 12. Okay, the 10 o'clocks do all end. I think we enter 12 o'clock when we enter our next recession. This country, probably in 2016 or into 2017. So you can see that the average length of a 10 is 27 months. We're currently 23 months into this one. The average— the length average— the longest has been 4 years and a month, the shortest 8 months. So historically, we are approaching an average length late-cycle bull market and an average length of time for a business owner to begin to exit their company. How bullish are they or bearish? And this again is S&P 500 returns. 10 to 12s are extremely bullish. They average 54% return in the S&P. Minimum of down 80 basis points, max up 128. Currently sitting at 27.4 on the S&P since July 31st, 2013. Growth stocks, what about over here or large cap over small? So large cap stocks in the public market dominate in late cycle bull markets. 1,000 basis points historically. This time around, 500. And growth stocks beat value stocks. And as you see all these IPOs coming to market, if you can have a growth story at this point in a market cycle, the market will pay you for it. They will pay you for growth, even if it's future, right? Even if it's future growth, unpromised growth. But if the market sees a path for you to do that, and as you hit quarterly numbers, you continue to make those numbers, the market will continue to expand your PE multiple along the way. In large cap, the PE— the growth over value is significant historically, 1,100 basis points. And this time around as well, you can't make this stuff up, 1,100 basis points over in large cap— large cap growth over large cap value. In small cap, again, for a lot of the businesses that you interact with probably live even smaller than that. But you can see in small cap, it's much more of a dead heat. But this time around, in this cycle, growth is dominant over value, 1,400 basis points. So through this lens, through this lens, this market makes sense. So even as I said, if you had perfect hindsight 7 years ago and started to play out what the economic scenario might be like, it would be hard to predict that the M&A cycle would be doing extremely well. And that the markets would also be nearing all-time highs. But through this lens, you can see that it does— this market does make sense. And for business owners and those that consult to them, to me, it speaks to the advice that you should give to them if they are looking to sell potentially. And that is the thing— again, not a 40-year-old, not a 30-year-old who is just looking to potentially take advantage. But if someone is in their 60s and says, I want to do this for another 5 years, This information shows you things like 5 years probably is not an option. You either have to sell now or 7 or 8 years from now, because if the window closes at a market top, it takes, it takes an average of 7 years to get back to 9. And so a business owner will not be able to sell at a valuation which they will consider appropriate between 12 and 6, and even at 6 and 7, they're still— the values are not there. They will feel insulted, right, about the value that they'll be offered. So you've got to wait till 9 to even get in the ballpark, and to get back to a 10 tends to take another couple years after that. So think 7 to 9 years to get back to numbers that they would like, as like they're being offered today. A lot of business owners do say to me, no, no, no, I'm not selling at 10. I want to sell my business at 12. I want the last dollar. I caution them to please be cognizant of doing things like that because your ending is someone else's beginning, and they're going to be looking out into a recession. And their rebuttal to you will, of course, be, that was your growth, not mine, and I'm not paying you the multiple that you think you deserve because the growth was yours. So I say to people that you better grow your earnings because your multiple between 10 and 12 will begin to collapse. And at 12 o'clock, even looking at October of last year, if you have that type of memory, October of last year when our market, when our public markets corrected 10%, what I was told by talking to people in industry was that the M&A market also dried up very quickly. The window can shut very quickly at 12. And from what I've also learned, and again, some expertise, but what I've also learned is it takes about a year to culminate a transaction. And so if a business owner is thinking about doing it, you know, they better— we now better have a more than average length late-cycle bull market in order for that window to stay open even for another year. So again, the advice to people is Don't dawdle if you're thinking about selling. It's imperative. And again, I have no axe to grind because once 12 o'clock hits, once the market top hits, history says that multiples collapse and business owners stop selling basically. Right. The bid-ask spread gets wider and there are really no buyers at prices that sellers deem appropriate. And so you run into that issue. It can be fast, it can be for multiple reasons, right? There's so much going on in the world, this wheel really doesn't— it doesn't know, right? We haven't even discussed the issues in China, or the issues in Greece, or the issues in Puerto Rico. I mean, all these things are sort of bubbling up along the surface, and yet this thing is immune to them. It looks at much more greater economic cycles and things like that. And 10 o'clocks, right, late cyclical markets, they're volatile. And so you even get volatility, I think, within the M&A market and what people will pay for companies. And you get maybe some on-again, off-again. Even companies that decide to IPO, a lot of them then back away, file their S-1, but then don't come to market. So I think it's imperative that we all understand kind of what's transpiring. Thanks. And what advice we should be giving our clients. The other thing about me, I am neither bullish nor bearish innately. People say, oh, here comes Mortimer again, he's always been bullish. I've been with the firm for 3 years and I've been bullish since I got here. And to me, it's all about, I just want to be right. I just want to understand what's happening in markets, what they're signaling, and then take that data and present to as many groups as possible and infiltrate for us infiltrate and give proper advice to our clients. A lot of our clients, of course, are business owners, and when they sell, they must make that transition between business owner— now they have to move to investor. That's where we also come in. You know, for small business owners to make that leap can be difficult. They understand their business, they understand it's not volatile, they don't see the price fluctuations that they see in the capital markets, the public markets. And so we have to work with them also to make that transition. Because selling at 10 o'clock also means that you become an investor at 10 o'clock. And for some of them, it's, oh my gosh, it's so late, right? Why would I be an investor when a market top may soon be upon us? So we work with them very closely to help them through that transition as well. So to us, again, it's all about trying to understand what clients are doing. And I understand that companies— you are all much closer to companies than I am. All companies have idiosyncratic issues. Some lead the economic cycle, some trail it. But through this lens, I hope that I've brought to you both what the— both from what the public markets are signaling, sort of another tool in your— in your— another arrow in your quiver that allows you to give proper advice to your clients. I think we will all be surprised how quickly— how quickly this window may close. And we are all— we are already getting to an average length late cycle bull market. And a lot of people write it's long in the tooth and all these types of things, and I hear that as well. But I still think with a gun pointed to my head that we've probably got another couple years to go. I don't think we run into recession in this country until probably, like I said at the beginning, end of 2016 or even into 2017. But if you get to the 49-month level, understand that you, you break up, right? You go You're gonna need that type of length in the late cycle bull just to sort of keep it open that long. You'd be then historically very long, very long in the tooth. So I question, again, my advice to business owners at this juncture is don't dawdle. If you are thinking about selling your business, begin to position it now for sale. And I doubt that you will look back and be embarrassed with the price that you paid, the price paid for your business. Right. A lot of people have remorse, seller's remorse. And if you sell your business at 10, historically, you have very little seller's remorse, very little, because the P/E that you'll be paid, well, then, right, could disappear. And you may look back and find yourself being extremely smart to have done that. And it's all for me again what the public markets are signaling, because all I've done is I overlaid, right, multiple data, multiples data on sort of the cycles that the stock markets go through, uh, throughout time. So I hope again it gives you some information as to the current status, when it started, and when we think it unfortunately might end or will end. Now I do think I bring some good news and that is that we have all lived through a lot of dual-stage bear markets. We went through two dual-stage bears in 2002 and 2008. And so a lot of people think, well, if we get to another 12 o'clock, then we have to suffer another 50% decline in the equity markets because that's what 12 o'clocks mean. That's what we've been conditioned to think. So I'm here to present some good news, and that is regularly throughout history, 12 moves to 3, 3 to 6 is skipped, completely omitted. 12, 3, 7s are very common. And I think we don't get another dual-stage bear market because we have 2 of them in 6 years. They're supposed to happen once in a generation. And because they happen so close together and the volatility scars that we all have, I don't think we get another dual-stage bear another 50% drawdown in my lifetime. I'm 52. I think we get very tame bear markets in here, moving over to 7 o'clock and then allowing, right, the markets to sort of push up from there. So that's sort of good news to the entrepreneur who's thinking about selling now, lets the window close on them, that maybe it's not a 7-year wait, maybe it's a 5 or 6-year wait, but it still will be some time before that confidence is restored. Reinstilled in markets and that people are willing again to transact and buy businesses. So that in a nutshell, again, I view public markets, I do asset allocation work, but this is getting a lot of traction in some areas of the country as I go around speaking, especially to investment bankers and private equity folk, because I've looked at the world through a different lens coming to very similar conclusions that they are, and helping them understand cycles, how long they last, and what they can sort of expect going forward. So I hope it was of help to you, allowing you to— again, with a person with no axe to grind— to give you some insight into how I look at the world and how it can apply even to people who are not even investing in the public markets but instead invested in private markets, and the advice that you give to business owners. So with that, I thank you all very much and enjoy the rest of the conference.