British takeover trend benefits shareholders

Serious Money: Outbreaks of sanity in British boardrooms have come as a welcome surprise to investors who have grown weary of the grandstanding of many a chief executive. UK banks are a prime example. Markets have been extremely wary of these businesses, partly because of the current position of the UK economy in general and the housing market in particular.

The main revenue stream for banks has been under threat because customers have started to borrow less: this leads to less income both directly and indirectly - banks make money not just on the loans they write, but on all those other things like payment protection policies.

Share prices of UK banks had a woeful 2005, mostly because of worries about the mainstream business of lending. But signs of economic stability and a recovery in the housing market started to assuage some of these concerns towards the end of the year.

These rather orthodox ways of thinking about banks only go part of the way to explaining share prices. Another key driver has been investor awareness that while growth may be slowing, these are still fabulously profitable businesses.

Even if the underlying business is not expanding, banks still throw off huge amounts of cash, and it is what management do with that cash that has been the question exercising the minds of investors.

UK banks have a very chequered acquisition history. There are as many examples of disastrous mergers as there are of deals. So, we have a situation where a once fast-growing industry is slowing down - perhaps, in the jargon, even going ex-growth - and management teams are wondering what to do about this while sitting on piles of cash.

A very natural question arises: will chief executives find that cash burning a hole in their pockets and start to do value-destroying deals?

Market concerns about all of this were highlighted last year when Royal Bank of Scotland (RBS) bought an interest in a Chinese telephone company. Investors took the view that this was likely to be wholly value destroying, with any such investment representing a complete waste of money. The amount of cash involved was relatively small, but it was instructive that the market capitalisation of RBS fell by more than the amount of the muted investment. Investors took the view that not only was the investment likely to be entirely wasted, but that it signalled future spending that would be equally wasteful.

By inference, it was clear that investors would simply prefer the banks to return their surplus capital to shareholders either via dividends or share buybacks. RBS didn't help its cause when we became aware of a new marble-encrusted HQ: investors became convinced that their interests were going to be ignored by a management team bent on pursuing trophy assets that would do little to enhance the bottom line.

Vodafone is the other obvious example. Management has remained wedded to a global growth strategy in a business that has clearly gone ex-growth. The strategic dilemma facing all telcos is that voice revenues are on an inexorable path to zero. Like banks, these businesses nevertheless throw off - for the moment at least - huge amounts of cash.

Like banks, investors are petrified by the thought that management is going to blow this money on wholly inappropriate growth strategies. Chief executives brought up on growth find it difficult making the necessary adjustments when their business environment changes.

Last week, we got small signals that things might be changing. RBS pledged not to do any silly deals and committed to returning money to shareholders. Vodafone indicated that it will get rid of its underperforming Japanese assets and might return any proceeds via a special dividend. Both companies saw their share prices rise as a result.

The pressure on management to align corporate behaviour with shareholder interests is acute everywhere, but is at its greatest in the UK. Unlike the current furore in Europe over foreign ownership, nobody cares in Britain who owns the companies. As a result, management is beginning to realise that if they don't perform they could be made redundant by a new owner. BT is another large company rumoured to be in the sights of a private equity consortium.

All of the pressures being felt by these large companies are trickling down through the rest of the stock market. Deals are being done everywhere. BAA, the airport authority, is being stalked by a German company. Pilkington, the glass maker, is the subject of a bid by a Japanese rival. Cross-border acquisitions in 2005 ran at a record pace.

Hence, the forces compelling management to behave come from a variety of sources. To be fair to beleaguered chief executives, it is not all the result of management incompetence. External factors have conspired to make many of their share prices even cheaper than needed.

Daft behaviour by regulators and so-called investment professionals has led a steady stream of forced selling of equities, leading in turn to lower share prices.

Given the UK's propensity to allow takeovers - unlike much of Europe - British companies are bought simply because it is relatively easy to do so. Transparency and well-regulated markets - again, unlike parts of Europe - also helps.

Investors who focus on gloomy forecasts for the UK economy will miss all of this. British companies have always been international and are becoming more so. An investment in a basket of British shares is essentially a purchase of the world economy and an investment in management teams who are becoming increasingly shareholder friendly.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.