Monday, March 9, 2015

Lessons Worth Remembering

Warren Buffett’s letters are always worth reading. The 2014 letter is no exception. In this post I will comment on three acquisition related topics raised in that letter. The first topic concerns risk. He highlights that risk is not volatility. Risk is the exposure to consequences from uncertain events leading to permanent capital loss. Academics focus on volatility because it is easier to measure and quantify than the exposure based definition. Nonetheless, putting a probability distribution (usually the highly questionable normal distribution) on an event does not make it less certain. Worse, it can lead to unjustified over confidence leading to Black Swan type surprises. Most of what passes for risk analysis is nothing more than simple extrapolation of recent history. It is experience v exposure based. Furthermore, it ignores perhaps the biggest risk of all in M&A; namely price risk (see next paragraph). We should instead focus on total v systemic risk and use scenario analysis and sensitivity charts to gauge its effect.

Next, is the need to distinguish intrinsic value from price when evaluating acquisitions. Premiums to market and comparable transaction multiples relate to the price you have to pay now. Intrinsic value concerns what you hope to receive in the future. They are not the same thing. Keep in mind the following:

1)     What you pay = pre bid price + premium
2)     What you get = standalone value + synergies
3)     Usually the pre bid price equals the standalone value - if markets are reasonable efficient
4)     Thus, the transaction’s net value added depends on synergies exceeding the premium

Synergies are of course an expectation-hence risky as they may not materialize. The key is to avoid fanciful synergies-leave a margin of error/safety to cushion your downside if something unexpected (risk) occurs. Gauging the validity of synergies considers the following:

1)     Expense cuts are more believable than revenue growth
2)     Acquirer’s track record. An experienced acquirer has better chance of achieving synergies
3)     Expected performance consistent with industry base rate
4)     Acquirer is the best owner of the assets based on business model fit

Last, avoid playing the EPS bootstrapping game. Initially, you can always increase EPS by either acquiring a firm with a lower PE ratio than yours (using your stock as currency) or borrowing to acquire the target’s earnings stream. Post close your PE ratio will adjust to reflect the quality of earnings, growth and risk involved - AKA there” ain’t no free lunch or magic”.

The above represent simple principles to follow when in the heat of a transaction. Although simple to express they can be difficult to apply and seem to be constantly re-learned .


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