Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J

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 .

j

Warren Buffett: Dividends and Acquisitions

Warren Buffett’s Berkshire Hathaway BRK is facing a dividend challenge from a small investor. The investor is seeking a resolution to be voted upon at BRK’s annual May meeting. The resolution calls for a regular dividend. BRK argues against the resolution on technical grounds stating the board already decides each year on shareholder distributions. To date BRK has not paid a dividend, although it has engaged in share repurchases when it considers its shares undervalued (defined as share price< 120% of intrinsic value).  Initially, it appears the investor may be right. Essentially, he argues as follows:

1.  BRK’s share price has lagged the S&P 500 index for 5 years
2.  Buffett admits having difficulty investing BRK’s huge cash flow and cash balances
3.  BRK is “elephant hunting”-looking for big deals
4.  The elephant hunting may result in forced errors
5.  Investors could better use the funds if they were return to them via dividends as repurchases would be ill advised at BRK’s current share price

Sounds like an approach used by activists like Carl Icahn against similar large firms with excess cash (e.g. Apple).

Buffett correctly points out dividends do not directly affect shareholder value. Dividends merely distribute value-they do not create value. What matters is who can invest the funds better-the firm or the shareholder. If the firm can do so thru organic or acquisition investments then it should retain the funds and make the appropriate capital allocations. Otherwise, the funds should be returned to shareholders. The decision rule is to retain and invest provided the expected returns exceed the cost of capital. The Dividend Discount Model shows Share Price=Dividend/ (Cost of Equity-Growth) where Growth= (1-Dividend Payout Ratio) x Return on New Investment. If investors need cash, then a better alternative, which may be more tax efficient, is for them to create homemade dividends by selling some of their shares.

Buffett’s record demonstrates good long term capital allocation decisions-albeit the last 5 years have been more problematic. Buffett, unlike the firms Icahn targets, eats his own cooking. Thus, the risks of value destructive capital misallocations from Agency Costs are reduced. BRK is more like long only hedge fund than a traditional maturing firm continuing to invest in declining projects. BRK can chose from a number of undervalued opportunities. I remember the last time Buffett was attacked as losing his touch in the 1990s with the tech boom. He was subsequently proven right.

I would trust Buffett for now to continue make good investment decisions. The dividend decision can be reconsidered should that trust turn out to be misplaced. For now, advantage Buffett.

J

Rolls Hubris Hypothesis and Acquiring Firm Returns

I've heard management professors and some consultants throw around comments like "Seventy percent of all acquisitions fail."  I don't believe it and the statistical evidence doesn't support that claim.  True, there is a lot of evidence that suggests bidders break even or lose a few percent at the announcement of a bid.   The combined returns to bidders and targets, appropriately weighted for size, are positive.  The typical deal creates value.   What I might believe is that 70 percent (or more) of mergers fail to realize their potential.  But that is typically a problem of integration and the subject of other posts. 

So what do we make of the continuing story that bidders tend to lose or break even?  After all, bidding activity continues to be quite popular (even if currently dampened).   There are many explanations in the literature to explain bidder returns.  Today, I will mention two.

The first is the possibility that we, as researchers, are not measuring returns correctly.  In a recent paper published in the Review of Financial Studies we present evidence that the typically measured bidder return doesn't adjust for anticipation.   When returns are measured correctly bidder returns are positive.  See (Anticipation, Acquisitions and Bidder Returns.)  

But let's return to the fact that some deals, however measured, do result in the loss of value to the acquiring firm.  Even in our sample this occurs as much as 40% of the time.  Why? A good place to start looking for the answer is in the price paid for the target.  As we have noted, Every deal is a bad deal at some price.  Not every deal is a good deal at some price.

In an efficient market, the value of a firm's shares are priced correctly.  Why would bidders typically add 20-40% to the market price in their bids?  Why would bidders pay more than this? The obvious, and always cited reason is synergies.  Synergies, of course, can be easily overestimated and in other posts we note that you should always challenge the assumption of synergies.  Why are they available to your firm and to no one else?  

Another reason to explain high bid prices is behavioral - the hubris factor. Roll (1986) was the first to point this out in the finance literature.  

Anyone who has bid for an object on Ebay understands that it is easy to overpay, to go beyond the rational limits we might set in advance on our bids.  We get caught up in deal fever or a desire to 'win' regardless of price.  The same behavior must certainly be true of at least some acquiring managments.  One can imagine the psychological pressures on management in certain bidding wars.  Multiple sides express multiple views with many unkind words and suggestions.  If psychological factors lead bidders to go beyond pre-determined boundaries (or equivalently if management directly or indirectly causes their own analysts to overestimate the gains to mergers in setting those boundaries) shareholders lose.  As we have noted, some of the best deals are those not attempted or in this case, not completed.  

One of the best illustrations of the hubris phenomena are found in the words of Warren Buffett, quoted in a previous post,

"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently, they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

We'll continue this discussion in two ways in the future.  One will be through an analysis of other factors related to bid premia and to bidding and acquiring returns.  A second avenue of analysis will continue to explore the role of behavioral factors in mergers and acquisitions.

All the best,

Ralph 

Deals of the Year for 2013

Deal activity was much higher this year than last, but not at the pace we expected.  See Joe's recent post 'Something is happening here, what it is ain't exactly clear.'  Still, the years is over and we can look back at the highlights.

Investor Place gives a nice tally of the ten biggest deals of the year.  There's an interesting set of stories here, from bankruptcy and regulatory issues (US Air/American Airlines),  private equity (Silverlake and Dell)  Warren Buffett (H. J. Heinz), industry consolidations (Publicis Groupe/Omnicom Group and Applied Materials/Tokyo Electron) and size - the third largest transaction of all time (Verizon and Vodaphone).  See the complete list and more detail here.

All the best,

Ralph

Find Your Sustainable Competitive Advantage

“In business, I look for economic castles protected byunbreachable ‘moats’.”

Warren Buffett

Famed investor Warren Buffett is known to favor companies with a 'natural moat', a built in protection that gives companies some protection against competition.  Economists call this a sustainable competitive advantage.  The idea is simple, find what you do well, better than anyone else - that is your competitive advantage.  But you need more.  It isn't enough to have a competitive advantage - you need a sustainable competitive advantage.  If someone can start up a new business tomorrow, delivering the same product and service as your company, you don't have a sustainable competitive advantage. 

Sustainable competitive advantages come from many sources.  In some industries, larger companies benefit from economies of scale making it hard for smaller companies to enter. Other advantages are created through access to supplies or raw materials.  This can occur naturally from the physical location of a company or access many be driven by relationships - familiarity with a particular country, etc.  Intellectual benefits occur when a company has a particular patent or copyright that others cannot duplicate.  

On an individual level an example of an intellectual benefit combined with relationships would be the economist Larry Summers, a leading contender to be next chairman of the Federal Reserve.   Obviously a very smart individual, Summers has honed his personal competitive advantage through a career of challenging positions and a myriad of political contacts.  Of course, competitive advantages in politics are often unsustainable, and it is not assured that Summers will be chosen for the Fed post.  Nevertheless, the comparative advantage will serve him well in multiple pursuits and the intellectual capital and connections are indeed sustainable.

In developing business (and personal) strategy, look for situations where barriers of entry exist, or create a sustainable advantage by differentiating your product in ways that are hard to reproduce.  Soft drinks are a good example.  Coke and Pepsi are trademarks that are known throughout the world.  Other soft drink companies come and go - but none have risen to the level of Coke and Pepsi.  Those two brands are the go-to soft drinks of the world.  

This doesn't mean that companies with well established brand names are immune from competition.  Just think of Kodak.  A dramatic catalyst  can easily change the fortunes of a company - or an industry. For Kodak it was technology.  Other catalysts include regulatory shifts, demographic changes, political events, and changes in consumer tastes.  Which brings us back to Coke and Pepsi.  Noticing a shift away from colas, Coke has broadened its product line to include drinks like Dasani water, Powerade and Minute Maid and non-drink products like Dannon that can still benefit from the company's distribution and promotional expertise.  Excellent companies adapt to keep the competitive advantage sustainable.  

Acquisition Returns and Unresponsive Toads

Financial academics have been analyzing mergers in a scientific fashion for over 30 years.  One thing that has always puzzled me about this research is the accepted result that bidding firms either break even from acquisitions or lose a few percent on the deals they make.  (This tendency,  incidentally, helps explain one arbitrage strategy in stock deals, buy the target and short the bidder.)

But accepting this result doesn't tell us why bidders would undertake such deals.  Many explanations have been given.  Until recently, the arguments that seemed most plausible were a) that returns were driven down by competition for the target (bidding wars) or b) that the bidding firms get carried away with their own power - believing that they are endowed with greater abilities to manage a target.  Obviously, these two items are related.  The difference is that the explanation under (a) still allows for bidders making profitable deals.  Explanation (b) implies overpaying.

On Monday, I'll present new evidence from research we have conducted showing that bidders do indeed earn significantly positive abnormal returns when deals are announced - we just have to measure them correctly.  But our results don't imply that explanations (a) or (b) are incorrect.  All three explanations can and probably do hold water.  Competition does drive down returns, and while the typical deal is profitable when measured correctly, many deals lose money for bidders.

So today, I focus on the hubris explanation.  This idea was  first mentioned in the academic literature by Richard Roll in 1986 but I conclude with a non-academic and more entertaining analysis of the issue - a quote from Warren Buffett.


"Many managers were apparently over-exposed in impressionable childhood years to the
story in which the imprisoned, handsome prince is released from the toad's body by a kiss
from the beautiful princess.  Consequently they are certain that the managerial kiss will
do wonders for the profitability of the target company.  Such optimism is essential.
Absent that rosy view, why else should the shareholders of company A want to own an
interest in B at a takeover cost that is two times the market price they'd pay if they made
direct purchases on their own?  In other words investors can always buy toads at the
going price for toads.  If investors instead bankroll princesses who wish to pay double
for the right to kiss the toad, those kisses better pack some real dynamite. We've observed
many kisses, but very few miracles.  Nevertheless, many managerial princesses remain
serenely confident about the future potency of their kisses, even after their corporate
backyards are knee-deep in unresponsive toads." 

(Warren Buffett in the 1981  Berkshire Hathaway Annual Report)

On Monday - what impacts returns to acquiring firms and how to measure them more accurately.

Have a great weekend,

Ralph