Mindful of Bubbles in a Boom for Deals

Warren E. Buffett has teamed up with 3G Capital to buy the venerable H. J. Heinz Company for $23 billion. But the famed value investor isn’t exactly buying low: when the deal was announced on Valentine’s Day, Heinz shares were trading at a record high of nearly $61. Had Mr. Buffett and his partners bought a year ago, shares were selling for $53, a 13 percent discount.

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Mr. Buffett is hardly the only buyer pursuing deals now that the stock market is hitting levels last seen in 2007. The Wilshire 5000 index recently set a record, and the Dow Jones industrial average has pierced 14,000 several times in the last three weeks.

Thomson Reuters reports that during the first two months of 2013 there have been over a thousand deals valued at almost $163 billion in total. That’s more than double the amount for the same months in 2012. If this blistering pace continues, merger and buyout deals could surpass $2 trillion in 2013, far more than the $1.57 trillion in 2007.

We all know what happened after that. From its peak in October 2007, the Standard & Poor’s 500-stock index plunged 56 percent.

“Buy low and sell high” is probably the most common adage in investing. So why do so many highly paid chief executives of acquiring companies persist in doing the opposite

Mr. Buffett, it should be said, may be the exception that proves the rule, since he’s been among the few willing to make big deals when stocks are cheap.

His company, Berkshire Hathaway, completed a $34 billion purchase of Burlington Northern in November 2009, when the S.& P. 500 hit an 11-year low. It surely ranks as one of the best deals ever, since stocks generally, and railroad stocks in particular, have surged since then.

Mr. Buffett kept busy throughout the downturn, buying profitable stakes in Goldman Sachs and General Electric in the depths of 2008 while also bolstering investor confidence.

But even Mr. Buffett can get swept up in a deal-making frenzy. He called his 2007 investment in the Texas utility TXU bonds a “huge mistake” and “unforced error.” The $45 billion TXU buyout, led by Kohlberg Kravis Roberts, a veteran deal maker and buyout firm, still ranks as the biggest leveraged buyout ever â€" and may turn out to be one of the worst.

“You always see a lot of M.& A. activity when the market is overvalued,” Matthew Rhodes-Kropf, an associate professor at Harvard Business School who has studied the phenomenon and also advises private equity and venture capital firms. “Of course, you only know a market peak with benefit of hindsight. But when you look back, you’ll see a lot of M.& A. activity.”

One reason is that there has to be two sides to every deal, and, “When prices are low, sellers don’t want to sell,” Professor Rhodes-Kropf said. “They know their stock will go up with even modest growth. All they have to do is hang on.”

The same thing happened after the recent real estate crash, when owners withdrew their homes from the market rather than sell at fire-sale prices, and the number of transactions plunged.

Conversely, as stock prices rise, some executives start to worry about their ability to meet investors’ growth expectations and whether their stocks are getting overvalued, Professor Rhodes-Kropf said. A merger or buyout may provide an attractive option, both for the seller, who can cash in at a premium, and the buyer, who gets immediate revenue gains and may benefit from the growth prospects at the newly acquired company.

Professor Rhodes-Kropf’s research suggests that mergers and buyouts occur disproportionally in overvalued industries and overvalued companies.

Still, that doesn’t explain why so many mergers and buyouts occur when the stock market is as overvalued as it turned out to be in both 2000 and 2007. You’d expect sellers to be plentiful, but not buyers.

Stephen A. Schwarzman, chairman and chief executive of Blackstone Group, one of Wall Street’s best-known and most successful deal makers, told me this week that early in the merger cycle: “You typically buy companies that are in the same industry or where there’s a fit. Those deals tend to be smart, pretty reasonable, and they usually work.”