Why I Avoid Acquisitive Companies

When I first got into investing I didn’t care whether a company was acquisitive or not, but the longer I invest the less I like acquisitions. Any roll-up strategy is an instant pass for me. Two things have slowly changed my views over the years.

First, there’s a lot of evidence that acquisitions (especially large acquisitions) are a poor way to grow a company. According to a McKinsey study, the average acquisition has historically increased the value of the combined entities by 5.8%. The problem is, more often than not, all of this increased value is transferred to the shareholders of the acquired company via the premium paid (i.e. goodwill). The average public company acquisition is made at a 30% premium to its previous day close. Increasing an acquired company’s value by 30% just to break even on the price paid is a hard enough task as it is, let alone earning an adequate return on top of that. Another interesting note is that M&A activity peaked in 1999 and again in 2007. It seems managers are all too prone to make acquisitions when times are good and valuations are high.
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Podcast with Eric Schleien

Two weeks ago I was on Eric Schleien’s The Intelligent Investing Podcast. We spent most of the podcast talking about two of my favorite long-term compounders, Where Food Comes From (WFCF) and Interactive Brokers (IBKR). We also mention Franklin Covey (FC), Elbit Vision Systems (EVSNF), and a handful of other more general investing topics. Click below to give it a listen. Cheers.

Episode 9 – The Intelligent Investing Podcast

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Book Review: Sam Walton Made In America

“I still can’t believe it was news that I get my hair cut at the barbershop. Where else would I get it cut?”

To me, that quote sums up Sam Walton’s autobiography. He was referring to a Forbes article that came out after he was named the richest man in the world. Forbes asked to come to his hometown to follow him around for a few days. Even though he allowed them to, it was a decision he regretted the rest of his life. He was a small-town country boy who hated the attention and that friends and strangers made a big deal out of his wealth for the rest of his life. Truth is, Sam never felt as wealthy as his net worth would suggest. He lived off a modest salary and Wal-Mart dividends, drove a pickup truck his entire life, and yes, continued to get his hair cut at a barber, which the rest of the world was apparently amazed by.

I have a lot of respect for people who are incredibly successful, yet remain humble. I’m sure it’s easy to let it all go to your head. His entire career, Sam was infamous throughout the corporation for how often he visited stores. I don’t know how many CEOs of multi-billion dollar companies do things like that, but I bet it’s not many. Sam loved the store-level part of the business and that never changed, even as his role evolved from manager of the first store to CEO of a global behemoth. Even towards the end of his life in his 70s, he was still out visiting stores on a regular basis. His wife and kids joke that all their family vacations involved visiting Wal-Marts and their competitors. Sam claimed he went in more K-Marts than anyone in the world. Given he never worked at K-Mart, that’s pretty damn impressive (who knows if it’s totally factual though). In addition to money never changing him, there were a few other notable characteristics that really stood out to me.
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Management Intangibles I Look For

Even though talking to CEOs is helpful, I don’t think it’s required in order to get an idea of how shareholder friendly they are. Last year I added a section to my investment checklist called “Management intangibles” where I go through a number of things that give hints as to what type of CEO I’m looking at. I like asking myself these questions because the answers to all of them are public information and/or fact-based. When talking to a highly charismatic CEO who is a natural salesman, it’s easy for the halo effect to take over and to think higher of them than I should. The halo effect is when we take one attribute of someone (this CEO is knowledgeable and talks with confidence) and assign them other unrelated positive attributes because of it (this CEO is shareholder friendly and a good capital allocator). It’s a human bias that we’re all guilty of (most commonly with attractive women) so it’s a good idea to try and counteract it.

I think combining these list items with my impressions from talking to the CEO leads me to a less biased opinion that’s more rooted in facts. So below is a list of all the things I go through in my intangibles checklist. None of these are deal killers and virtually all CEOs have the “wrong” answer on a few of them, but looking at them as a whole can give a decent picture as to what the CEO is like.
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Is the world getting better or worse?

“Tell me something that’s true that nobody agrees with.” That’s Peter Thiel’s favorite question to ask entrepreneurs. With it, he’s trying to find people with contrarian mindsets who have no problem believing in things that are not popular. When I first read that quote, I sat for a few minutes thinking of beliefs I have that might fit the bill. Sadly, one of the things I came up with is my optimistic view of the world (including American politics!). Even before Trump, it seems like I rarely run across someone who is optimistic about the overall direction of the world, but especially politics. Everyone thinks people are more racist, politicians are more corrupt, and the world was a better place a few decades ago. My response to that has generally been:

  1. Nostalgia bias.
  2. We’re only human. Don’t expect perfection.
  3. Not that I was alive pre-1987 to know for sure, but when I think about life expectancy, women’s rights, slavery, and the rise of democracy, it certainly seems like the world today is the best it ever has been. And 20 years from now, it will probably be better. And so on and so on.

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Peer Group Valuation Is (Mostly) Useless

A company’s value is its future free cash flow discounted back to the present. I doubt any readers will argue with me there. And when you break it down, the two things that determine future cash flow are return on invested capital (ROIC) and growth. So if ROIC and growth are the two determinates of future value, then to have a fair peer analysis the included companies should have similar returns on capital and growth prospects. If two companies have different ROICs or growth prospects then it’s not an apples-to-apples comparison.

Having similar growth potential also insinuates the two companies are in the same stage of their life cycle, meaning they’re similar sizes. So including mature businesses in a peer valuation for a small-cap company is meaningless. When a company is selling for less than its peers, it’s almost always because it has lower returns on capital or its growth prospects are not as good as its competitors. There are a few other factors that play into this as well.
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Don’t Let Numbers Deceive You

One of the reasons the recent presidential election was such a surprise was that all the major polls showed Hillary holding a sizable lead right up until election night. There are many theories on why the polls were wrong, but two ideas struck a chord with me.

First, what people say they believe can be very different than what they actually believe. If someone is asked a question (who are you going to vote for?) and they’re embarrassed by their truthful answer, they might lie (answer with another candidate) or downplay it and say undecided. In theory, lying in polls will balance out with a large enough sample, but I don’t think that was the case in this election (Trump supporters were less likely to admit who they were voting for). Second, surveys done online or by telephone will always be skewed in some way. I doubt the group of people who are willing to sit on the phone for 5-10 minutes to answer a survey is a random sample of the entire population.

Those two theories about the failure of the presidential polling prompted me to review my notes from a book I read a couple years ago called How to Lie with Statistics. Whether given to us by management teams or discovered through research, investors are always looking at numbers. I think it’s a good idea to remind myself every once in a while how easy it is to be deceptive with numbers.
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