Should You Jump into the M&A Game?
As operational and technology consultants, we are contacted at least three times per month from larger RIAs saying, “A friend of mine just bought a $100 million practice – I want to do that too!” This is a common response from aspiring buyers as the industry is beginning to consolidate based on advisor demographics and the potential for literally trillions of dollars in AUM to be up for grabs is putting stars in everyone’s eyes.
Strategically, if you want to take your firm to the next level, pursuing an inorganic growth strategy makes a lot of sense (see: PFI Advisors’ M&A White Paper, “Becoming a Professional Buyer”). However, if it were so easy, then everyone would be doing it.
To illustrate this point, I then ask for their pitch to advisors… Why should they join you?
The advisor on the other end of the phone will almost always go immediately into his client pitch. I stop these advisors every time and say, “That’s a great pitch to your end clients, but that is not your advisor pitch. If you are going to get into the M&A game, you need to make the mental switch from B2C to B2B sales. It’s a completely different ballgame.”
A presentation to advisors, as opposed to clients, should be about the back office and infrastructure capabilities of your firm. Advisors interviewing you as a potential landing spot for their business are listening for how you will make their lives easier: Can you take away the administrative hassles they have been dealing with while running their own business? Can your current infrastructure handle the increased number of clients and accounts that this merger will add to your workflows?
Having had this conversation for several years, I was extremely impressed with Timothy Stinson’s recent article in WealthManagement.com, “Why Your Firm’s Infrastructure is Key to M&A Growth.” Timothy astutely states, “In addition to the variables that typically influence deal-making in this space – such as culture, organizational structure and client synergies – in this new fiduciary era it is increasingly clear that having the right wealth management infrastructure will also be a key differentiating factor in M&A deals.” He continues by saying, “[Back office] tools that are a mishmash of multiple loosely connected parts typically result in a poor client experience, and given the expectations of today’s increasingly tech-savvy [clients], that’s a risk that no advisor should take with their business.”
In our own experience, we have witnessed failed acquisition attempts where the seller concludes, “My back office is in better shape than the potential buyer’s – why on earth would I join their firm and take a step back technologically?” Even with successful acquisitions, when we have worked with both firms to integrate systems and technologies, we don’t assume the larger firm necessarily has the “better” technology and processes – many times we recommend our clients keep a CRM or a financial planning tool that the acquired firm brought to the table (see: PFI Advisors’ InvestmentNews article, “Solving Operational Issues from M&A Transactions”).
In his WealthManagement.com article, Timothy defines a successful merger as, “The ability of the purchaser to realize the ongoing revenue streams from client relationships that stick around after a deal has been executed.” Therefore, he concludes, “Sellers need to seek out buyers that have scale, resources and expertise to comfortably incorporate a large number of clients into their practice.”
Timothy then provides three questions for would-be sellers to ask potential buyers before continuing with merger discussions:
- How many custodial platforms are you working with? To put this into my own words, can your firm accommodate data feeds from multiple custodians and provide timely, seamless portfolio reporting to clients?
- Where and how are your investment programs sourced? I believe the root of this question is, is the investment process at your firm easy to convey to clients? And probably even more important, does your investment platform offer sophisticated products and services that I didn’t have access to before joining your firm?
- Does your platform deliver a delightful client experience? Timothy points out, “Today’s consumers expect collaborative decision-making, transparency and easy-to-use tools/apps that provide worldwide access. Delivering these experiences is incredibly difficult, requiring advisors to meld technology, people, and process…but advisors who can’t deliver them consistently will see their business erode.”
Advisors who have not yet acquired another practice have not yet made that necessary mental shift. They have spent their entire career focused on the client experience and carving out a particular client niche to make their prospecting efforts more successful. They have oftentimes built their firm around customized systems and reports to provide clients a high-touch experience. In order to successfully compete in the M&A game, advisors must shift their thinking from “individual customization” to “scalability & efficiency” to provide a high-touch service to a larger client base.
With the aging demographics of the wealth management industry, coupled with the increased regulatory burdens being placed on smaller practices, more advisors will be searching to join a larger RIA in the coming years. As Timothy concludes his article, “This will either be a chance to achieve growth by acquisition or an enormous missed opportunity for those who may have the interest and all the right intentions but not the right wealth management infrastructure in place to capitalize on this trend.”
All the Talk of an Accelerating Economy and Rising Inflation Just Doesn't Add Up
The biggest news for the markets this week came from the Federal Reserve. On Wednesday, it released the January Federal Open Market Committee meeting notes and they were interpreted as dovish by some and hawkish by others as analysts raced to divine insight from the text.
The recent data isn’t supporting the narrative of accelerating global growth and inflation while equities continue to experience higher volatility. What does it mean for stocks, bonds and yields? Glad you asked! Here’s my take on why all the talk on an accelerating economy and rising inflation just doesn't add up when you look at the data.
Equity Markets — A Relatively Narrow Recovery
The shortened trading week opened Tuesday with every sector except technology closing in the red. The S&P 500 fell back below its 50-day moving average after Walmart (WMT) reported disappointing results, falling over 10% on the day, having its worst trading day in over 30 years.
Walmart’s online sales grew 23% in the fourth quarter, but had grown 29% in the same quarter a year prior and were up 50% in the third quarter. We saw further evidence of the deflationary power of our Connected Society investing theme as the company reported the lowest operating margin in its history.
Ongoing investment to combat Amazon (AMZN) and rising freight costs — a subject our premium research subscribers have heard a lot of about lately — were the primary culprits behind Walmart's declining numbers. To really rub salt in that wound, Amazon shares hit a new record high the same day. This pushed the outperformance of the FAANG stocks versus the S&P 500 even higher.
Wednesday was much of the same, with most every sector again closing in the red, driven mostly by interpretations of the Federal Reserve’s release of the January Federal Open Market Committee meeting notes. In fact, twenty-five minutes after the release of those notes, the Dow was up 303 points . . . and then proceeded to fall 470 points to close the day down 167 points. To put that swing in context, so far in 2018, the Dow has experienced that kind of a range seven times but not once in 2017.
Thursday was a mixed bag. Most sectors were flat to slightly up as the S&P 500 closed up just +0.1%, while both the Russell 2000 and the Nasdaq Composite lost -0.1%. The energy sector was the strongest performer, gaining 1.3% while financials took a hit, falling 0.7%.
The recovery from the lows this year has been relatively narrow. As of Thursday’s close, the S&P 500 is still below its 50-day moving average, up 1.1% year-to-date with the median S&P 500 sector down -1.0%. Amazon, Microsoft and Netflix alone are responsible for nearly half of the year’s gain in the S&P 500. The Russell 2000 is down -0.4% year-to-date and also below its 50-day moving average. The Dow is up 78 points year-to-date, but without Boeing (BA), would be down 317 points as two-thirds of Dow stocks are in the red for the year.
Fixed Income and Inflation — the Coming Debt Headwind
The 1-year Treasury yield hit 2.0%, the highest since 2008 while the 5-year Treasury yield has risen to the highest rate since 2010, these are material moves!
What hasn’t been terribly material so far is the Fed’s tapering program. It isn’t exactly a fire sale with the assets of the Federal Reserve down all off 0.99% since September 27 when Quantitative Tightening began, which translates into an annualized pace of 2.4%.
As for inflationary pressures, U.S. Import prices increased 3.6% year-over-year versus expectations for 3.0%, mostly reflecting the continued weakness in the greenback. The Amex Dollar Index (DXY) has been below both its 50-day and 200-day moving averages for all of 2018. The increase in import prices excluding fuel was the largest since 2012 and also beat expectations. Import prices for autos, auto parts and capital goods have accelerated but consumer good ex-autos once again moved into negative territory.
Outside the U.S. we see little evidence that inflation is accelerating. Korea’s PPI fell further to 1.2% - no evidence of rising inflation there. In China the Producer Price Index fell to a 1-year low – yet another sign that we don’t have rising global inflation. On Friday the European Central Bank’s measure of Eurozone inflation for January came in at 1.3% overall and has been fairly steadily declining since reaching a peak of 1.9% last April. This morning we saw that Japan’s Consumer Price Index rose for the 13th consecutive month in January, rising 0.9% from year-ago levels. Excluding fresh food and energy, the increase was just 0.4% - again, not exactly a hair-on-fire pace.
The reality is that the U.S. economy is today the most leveraged it has been in modern history with a total debt load of around $47 trillion. On average, roughly 20% of this debt rolls over annually. Using a quick back-of-the-envelope estimate, the new blended average rate for the debt that is rolling over this year will likely be 0.5% higher. That translates to approximately $250 billion in higher debt service costs this year. Talk about a headwind to both growth and inflationary pressures. The more the economy picks up steam and pushes interest rates up, the greater the headwind with such a large debt load… something consumers are no doubt familiar with and are poised to experience yet again in the coming quarters.
The Twists and Turns of Cryptocurrencies
The wild west drama of the cryptocurrency world continued this week as the South Korean official who led the government’s regulatory clampdown on cryptocurrencies was found dead Sunday, presumably having suffered a fatal heart attack, but the police have opened an investigation into the cause of his death.
Tuesday, according to Yonhap News, the nation’s financial regulator said the government will support “normal transactions” of cryptocurrencies, three weeks after banning digital currency trades through anonymous bank accounts. Yonhap also reported that the South Korean government will “encourage” banks to work with the cryptocurrency exchanges. Go figure. Bitcoin has nearly doubled off its recent lows.
Tuesday the crisis-ridden nation of Venezuela launched an oil-backed cryptocurrency, the “petro,” in hopes that it will help circumvent financials sanctions imposed by the U.S. and help improve the nation’s failing economy. This was the first cryptocurrency officially launched by a government. President Nicolás Maduro hosted a televised launch in the presidential palace which had been dressed up with texts moving on screens and party-like music stating, “The game took off successfully.” The government plans to sell 82.4 million petros to the public. This will be an interesting one to watch.
Economy — Maintaining Context & Perspective is Key
Housing joined the ranks of U.S. economic indicators disappointing to the downside in January with the decline in existing home sales. Turnover fell 3.2%, the second consecutive decline, and is now at the lowest annual rate since last September. Sales were 4.8% below year-ago levels while the median sales price fell 2.4%, also the second consecutive decline and this marks the 6th decline in the past 7 months. U.S. mortgage applications for purchase are near a 52-week low.
Again, that’s the latest data, but as we like to say here at Tematica, context and perspective are key. Looking back over the past month, around 60% of the U.S. economic data releases have come in below expectations and this has prompted the Citigroup Economic Surprise Index (CESI) to test a 4-month low. Sorry to break it to you folks, but the prevailing narrative of an accelerating economy just isn’t supported by the hard data. No wonder that even the ever-optimistic Atlanta Fed has slashed its GDPNow forecast for the current quarter down to 3.2% from 5.4% on Feb. 1. We suspect further downward revisions are likely.
Looking up north, it wasn’t just the U.S. consumer who stepped back from buying with disappointing retail sales as Canadian retail sales missed badly, falling 0.8% versus expectations for a 0.1% decline. Over in the land of bronze, silver and gold dreams, South Korean exports declined 3.9% year-over-year.
Wednesday’s flash PMI’s were all pretty much a miss to the downside. Eurozone Manufacturing PMI for February declined more than was expected to 58.5 from 59.6 in January versus expectations for 59.2. Same goes for Services which dropped to 56.7 from 58 versus expectations for 57.7. France and Germany also saw both their manufacturing and services PMIs decline more than expected in February. The U.K. saw its unemployment rate rise unexpectedly to 4.4% from 4.3%
The Bottom Line
Economic acceleration and rising inflation aren’t showing up to the degree that was expected, and this was a market priced for perfection. The Federal Reserve is giving indications that it will not be providing the same kind of downside protection that asset prices have enjoyed since the crisis, pushing markets to reprice risk and question the priced-to-perfection stocks.
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