This article on The Acquirer’s Multiple was written by Thomas Niel. Thomas is a private investor, a financial blogger and an accountant in Washington DC. Article image (creative commons) by Pictures of Money, edited by Broken Leg Investing.
Interested in finding a simple value strategy to help you beat the markets?
Look no further than The Acquirer’s Multiple!
On his blog Greenbackd, the hedge fund manager, blogger, and value investor Tobias Carlisle tied together the intersection of deep value investing and shareholder activism into a simple, accessible investing approach that became his magnum opus.
Providing value investors a primer on how to beat the markets, Carlisle’s book, The Acquirer’s Multiple, develops a simple quantitative method to investing in deep value stocks, similar to the approach we take here at Broken Leg Investing.
But what exactly is The Acquirer’s Multiple? How does shareholder activism tie into passive quantitative-style value investing? Read on to learn how the systems of billionaire contrarian investors provide a winning strategy for your portfolio.
Past as Prelude: The Bedrock of The Acquirer’s Multiple
The tenets of The Acquirer’s Multiple strategy have been in play since the beginnings of value investing.
The Acquirer’s Multiple employs “margin of safety,” but with a more complex multiple valuation as opposed to looking at discount to tangible book.
Like net-net investing, this approach requires investors to take a contrarian view. Not only do you have to avoid buying stocks “priced for perfection,” you also cannot buy Warren Buffett’s “wonderful companies at a fair price” or even Joel Greenblatt’s “Magic Formula” ideas.
You need to zig when the crowd zags!
This is the strategy that many legendary investors have taken to the bank for decades — and not only “activists” such as Carl Icahn. Investors not as interested in rattling cages, such as David Dreman, have built impressive track records buying out-of-favor stocks at low multiples.
Dreman’s success came from using a forerunner to The Acquirer’s Multiple strategy: low P/E. The Acquirer’s Multiple may use a more sophisticated valuation metric, but the key factor is finding profitable but out-of-favor companies that statistically will revert to the mean long-term.
What is The Acquirer’s Multiple?
What is The Acquirer’s Multiple?
The Acquirer’s Multiple is a valuation framework that compares a company’s enterprise value to its earnings before depreciation, amortization, interest, and taxes (EBITDA) or its earnings before interest and taxes (EBIT). The approach aims to assess the true cost a third party would have to pay to acquire a target company’s cash flow, or operating profits.
In the words of Tobias Carlisle:
“The Acquirer’s Multiple compares the total cost of a business to the operating income flowing into the company. It assumes the acquirer can sell assets, pay out the company’s cash, or redirect the business’s cash flows”.— Tobias Carlisle, The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market (p. 65)
The key ratio in the Acquirer’s Multiple is Enterprise Value (EV) to Operating Profits. Operating Profits equal a company’s EBIT (earnings before interest and taxes). But instead of calculated bottom up (adding back taxes and interest expenses to profits), Operating Profits is calculated top to bottom (revenues minus cost of goods sold minus operating expenses/G&A minus depreciation/amortization).
Utilizing Operating Profits as a metric of profitability allows for an apples-to-apples comparison of stocks with varying capital structures.
Note that this method does not always use the commonly used EV/EBITDA ratio. This ratio can be misleading when assessing the value of capital-intensive businesses such as auto parts manufacturers and airlines (which typically sell at low EV/EBITDA ratios) that need to constantly invest in equipment to stay in business.
What is Enterprise Value?
Enterprise Value is the total price an acquirer would have to pay to buy out all outstanding shares of a company (assuming no premium). EV encompasses the market value of common stock, the par value of outstanding debt, as well as the liquidation value of preferred stock. In cases where a public company does not own 100% of its operating businesses, a fair valuation of minority interest in these businesses is also included.
For example, a company with a $100m market cap and $50m in outstanding debt would have an Enterprise Value of $150m.
As Carlisle puts it, Enterprise Value shows us “the whole iceberg,” painting a complete picture of a company’s current market value.
The EV/Operating Profits metric can show how undervalued or overvalued a company is relative to peers.
For example, let’s say there are two stocks, both of which are in the widget manufacturing industry:
Company A has a $25 million market cap, zero debt, $10m in cash, and $3m in operating income. This gives us an Enterprise Value of $15m, and an Acquirer’s Multiple of 5.
Company B also has a $25m market cap, but $10m in debt and $5m in cash. Operating Earnings are also $3m. This company has an Enterprise Value of $30m, and an Acquirer’s Multiple of 10.
While both stocks have identical market caps and Operating Profits, company A sells for a lower valuation. Their disparate capital structures obfuscate this discrepancy.
The advantage of earnings-based deep value investing is the greater optionality that comes from buying stocks selling at valuations lower than peers.
Companies that sell at low valuations attract more activist activity, increasing the likelihood the company will enact changes that push the stock closer to intrinsic value.
Financial buyers (private equity) may be interested in buying up the business, turning it around or recapitalizing it for large profits. Strategic buyers (such as competitors) may come knocking as well, seeing an undervalued business in their industry as an earnings-accretive bolt-on acquisition.
The key takeaway is that undervalued yet profitable companies do not stay undervalued forever. Eventually, either their valuation reverts to the mean, or outside forces (financial/strategic buyers) serve as a catalyst to drive up the stock.
The Acquirer’s Multiple Strategy Has Crushed the S&P 500
Backtesting the criteria used in The Acquirer’s Multiple, investors would have seen their money compound at far greater rates than not only the S&P 500, but other investing “formulas” such as Greenblatt’s “Magic Formula”:
- $10,000 invested in the S&P 500 in 1973 would have compounded into $205,481 by 2017.
- $10,000 invested using the Magic Formula in 1973 would compound to $7.6m by 2017.
- $10,000 invested using The Acquirer’s Multiple strategy would compound to $14.9m by 2017!
Yes, past performance is not indicative of future results, but this long-term backtesting demonstrates the power of this simple investing method.
Wall Street darlings fall back to earth; the “dogs” bounce back from the bargain basement.
Ben Graham proved it in the 1930s. Buffett and Walter Schloss proved it in the 1950s and ’60s. Icahn and Dreman proved it in the ’80s and ’90s. Bill Ackman and David Einhorn have proved it in the 21st century. Contrarian deep value investing is a time-tested method to beating the markets and compounding a grubstake into a fortune.
Why the Smart Money Plays Using the Acquirer’s Multiple Strategy
The Acquirer’s Multiple strategy pays homage to the value strategies pioneered by Graham, but it borrows most from the playbook used by corporate raiders in the 1980s.
As documented in the fantastic book King Icahn, Carl Icahn used a similar metric to determine that moribund companies such as Tappan and Hammermill were deep value buys. By launching proxy contests to push for a sale/liquidation, he and his fund saw parabolic compounding of their capital.
In 1980, Icahn was a little-known arbitrageur; by 1990, he was a billionaire.
Other raiders made names (and fortunes) for themselves following a similar strategy. T. Boone Pickens, Ronald Perelman, James Goldsmith: these raiders had their own style, but the most important criteria for them was that their targets were extremely undervalued. Either they could profit by taking over the company, or they’d profit when a third party stepped up with a takeover bid of their own.
It was like taking candy from a baby.
Following the events that brought the ’80s takeover boom to a halt (1987 crash, insider trading scandal, the arrest of Michael Milken and collapse of Drexel Burnham Lambert), the corporate raiders went back to low-profile styles of investing.
At the dawn of the millennium, “corporate raiding” came back with a roar. Except this time, it had a better name: activist investing.
Legends of the past such as Icahn came back with brute force to shake up the destinies of companies, but a new crop began making moves and stealing headlines.
Dan Loeb, Ackman, and Einhorn entered the scene, building up impressive track records in traditional value investing (buying deep value stocks and waiting on a third-party catalyst/Mr. Market to realize intrinsic value) and leveraging their power to become activist investors in their own right.
The 21st century hedge fund “activists” used a subtler approach: they seldom used the threat of a takeover to achieve their goals. Instead, they utilized the power of the pen to shame boards into making changes that benefitted all shareholders.
But like the pioneers of the 1980s, these “activists” found their targets using Acquirer’s Multiple-style metrics — focusing on companies selling for relatively EV/EBIT valuations, they pushed hard for strategic changes and cashed in when they served as their own catalyst.
Warren Buffett is Skeptical of The Acquirer’s Multiple
One notable exception to the value investors who use a variant of The Acquirer Multiple are Warren Buffett and Charlie Munger.
Buffett has said Berkshire will never buy a company where the managers use EBITDA as a financial figure.
To both, depreciation is a real expense: it may be spread over several years on the income statement, but it is an upfront outlay on the cash flow statement.
They look at it as “reverse-float”-instead of getting cash upfront and paying for expenses later, you pay expenses outfront and only get the benefit over several years.
EBITDA can also be manipulated. As seen in the Enron and Worldcom scandal, it is easy for managements to inflate earnings by capitalizing expenses that should not be capitalized.
While the EBIT calculation appreciates the true cost of depreciation it also paints a misleading view: interest expenses are a cash outflow; tax is a cash outflow.
The EBIT metric is a great tool for making apples-to-apples comparisons across similar companies with disparate capital structures and effective tax rates, but it does not fully convey the profitability of a business.
Exceptions notwithstanding, the Buffett/Munger approach is oriented towards “wonderful companies at fair prices” mantra-the “high moat” stocks that can generate a consistently high return on capital.
While in hindsight this process looks easy-it takes the experience of prowess of an investor such as Buffett to find these gems. There are plenty of companies that at the height of the business cycle look like high moat businesses, but in ten years prove to be much more vulnerable.
The “wonderful companies at fair prices” approach may work well for a concentrated portfolio, a highly diversified portfolio that uses a mechanical screening method (such as Acquirer’s Multiple or Broken Leg-style investing) can generate big returns with little required soothsaying abilities.
How Carlisle’s “Deep Value” Turned History into an Accessible Investing Approach
But beyond providing a history lesson on the intersection of deep value investing, the evolution of shareholder activism, and the development of mergers and acquisitions (M&A) as a major catalyst, Deep Value develops a simple strategy based on these lessons that even small investors can adopt to beat the markets.
An Acquirer’s Multiple Strategy Blends Seamlessly with Broken Leg-style Investing
You probably have asked yourself what the origins behind our name Broken Leg Investing are. Towards the end of The Acquirer’s Multiple, Carlisle summaries what “the broken leg” problem is and how it pertains to deep value investing:
According to social scientist Paul Meehl’s Golden Rule of Predictive Modeling, simple rules are better at making accurate predictions than the prognostications of experts.
Broken Leg Investing uses a simple value strategy — a series of rules and criteria to find the strongest deep value investment opportunities.
But it is tough to overcome human nature and blindly follow mechanical rules. Herein lies the “broken leg problem”:
Let’s say we have a simple rule that can predict whether or not your friend will go to the movies with you. This system has proven in the past to be highly accurate, but in this instance your friend has a broken leg. You know full well your friend will be staying home tonight.
Does this knowledge mean you will make better predictions in the long run than the “simple rule”?
It doesn't. Many “broken leg” situations (additional information that clouds adherence to a simple rule) that turn out to be red herrings. In life and in investing, it is easy to make the wrong call based on irrelevant information.
Looking at moribund deep value stocks, you will find plenty of “broken legs” (declining business, unprofitable, bad business models), but in the aggregate, a portfolio of “fair businesses at wonderful prices” time and time again will beat the markets.
The toughest part is not developing the criteria, but sticking to the method. Quantitatively investing in stocks can seem boring, but crushing the market long-term more than makes up for it!
The Acquirer’s Multiple is yet another simple value metric you can apply within a Broken Leg-style method of investing.
As history has shown, this approach works!
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