The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market

by Tobias E. Carlisle

In this book, I show how to find those fair companies at wonderful prices. And I explain in plain and simple terms why they beat Buffett’s wonderful companies at fair prices.

We wrote about the test in 2012 and again in my 2014 book, Deep Value. It did well for an expensive, quasi-academic textbook on valuation and corporate governance. But I wanted one that could be read by non-professional investors. This book is intended to be a pocket field-guide to fair companies at wonderful prices. Its mission is to help spread the contrarian message. It’s a collection of the best ideas from my books Deep Value, Quantitative Value, and Concentrated Investing.

Tobias Carlisle is the founder and managing director of Acquirers Funds, LLC. He serves as portfolio manager of Acquirers Funds managed accounts and funds.

He is the author of the bestselling book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance). He is a coauthor of Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors (2016, Wiley Finance) and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance).

Sometimes investors use company (or corporation) and business as substitutes. They are different. A company is a legal entity. It owns the assets. It employs the staff. It enters into the contracts. It can sue and be sued. Business is the activity of selling goods or services with the aim of making a profit. Shareholders own shares in the company. The company owns the business and the assets. A business can be worth a lot, worthless, or worth less than nothing if it’s regularly losing money. Also, a company can have lots of value, or it can have a negative value if it owes more than the assets it owns. Many investors closely watch profits—the fruits of the business—but ignore assets, including cash.

Why buy a company with a failing business, even if it is undervalued? There are three reasons:

What causes mean reversion? How does the high-growth, high-profit stock fall back to average? How does the undervalued stock rise to fair value? Benjamin Graham once described this as “one of the mysteries of our business.”[xi] He was being a little modest. The microeconomic answer is simple-ish. The answer is competition.

Fast growth and high profits attract competitors—entrepreneurs and businesses in related industries. Competitors eat away at the growth and profit. Losses cause competitors to fold or simply leave the industry, and the lack of competition creates a time of high growth and profit for the surviving businesses.

The ebbing and flowing of competitors cause mean reversion at the business level, but what causes it at the company level? How do undervalued and expensive stocks get back to fair value? The answer is other investors. Fundamental investors. Value investors.

Undervalued assets and profits attract investors. Value investors and other fundamental investors start to buy stock and so push up stock prices. Expensive assets and profits cause those investors to sell. The selling pushes down stock prices.

Mean reversion has two important implications for investors: Undervalued, out-of-favor stocks tend to beat the market. The more undervalued the stock, the greater the return. Value investors call the difference between the market price and the underlying value the margin of safety.

The bigger the margin of safety, the better the return. This is why we ignore advice like the old saying, “Never catch a falling knife.” Undervalued stocks are lower risk than glamorous, expensive stocks, which have no margin of safety.

Fast-growth or highly profitable businesses tend to slow down or become less profitable. Declining or unprofitable businesses tend to do better.

Investors make the error worse by overpaying for unsustainable growth or profit. They extrapolate out the profit trend and buy. If the stock delivers on the promised growth or profit, it only earns a market return. If it doesn’t, it gets crushed.

They buy at what looks like the worst possible time, when profits are falling or losses are widening, and it looks like this will continue until the crashing stock hits zero. It’s the worst-case scenario. But the stock is undervalued, and it offers a wide margin of safety. It’s time to buy.

The magic formula beats the market, just as Greenblatt claims. But what’s the true cause of the market-beating results? Here’s the twist. Fair companies at wonderful prices—what I call the Acquirer’s Multiple—do better. In this test, we buy the most undervalued stocks with no regard for profitability. (We talk about our test and the results in detail in a later chapter.)

In our test, the Acquirer’s Multiple—fair companies at wonderful prices—beats the Magic Formula—wonderful companies at fair prices. It seems the size of the margin of safety—the market price discount from value—is more important than profitability.

Does this mean that Buffett is wrong about wonderful companies at fair prices being better than fair companies at wonderful prices? Does Buffett’s liking for wonderful companies at fair prices disagree with the idea of mean reversion in profits? In short, no. Buffett seeks stocks with sustainable profits, those that have what he calls a “moat”—in other words, a competitive advantage. A moat is something that allows a business to beat its competition.

The problem for investors is it’s hard to find businesses that can keep up high profits. We can’t predict what businesses will maintain profits. Even if we look for high past profits and the reason why—the moat—most businesses see profits fall over time. In a later chapter, we try to identify moats in a scientific, repeatable way. But our chance of finding a business that can sustain profits is still as good as flipping a coin. There are three reasons why:

See’s made just less than $5 million pretax in 1971. It earned a huge 60 percent profit on its $8 million in hard assets ($5 million ÷ $8 million = 60 percent). Let’s assume a discount rate of between 10 and 12 percent. (In 1972, we could get 6 percent leaving our cash in the bank. We add on a little extra—4 or 6 percent—because See’s is riskier than a bank account.) In that case, See’s was worth between five and six times its hard assets (60 percent ÷ 10 or 12 percent = 5 or 6 times). With $8 million in hard assets, See’s was worth between $40 and $48 million (5 or 6 × $8 million).

In 2007, twenty-five years after Buffett bought it, See’s earned $82 million on $40 million in hard assets. That was an amazing 195 percent return on assets. The huge growth in profit—from $5 million to $82 million—happened without much more invested in its hard assets. See’s paid out to Buffett almost all the profit it made between 1972 and 2007: $1.4 billion. And See’s invested only $32 million to grow its hard assets ($40 million – $8 million = $32 million). Buffett got to use most of See’s $1.4 billion in profit to buy other high-profit businesses for Berkshire. This is why Buffett described See’s as “a dream business.” He compared See’s to an ordinary business. He guessed an ordinary business needed about $400 million in hard assets to make the same $82 million profit as See’s. Buffett means an ordinary business earns about 20 percent on its assets ($82 million ÷ $400 million = 20 percent). That’s very high. And it would still be worth less than See’s.

For example, let’s say we have two businesses, each earning $1 million in profit. One has $5 million in assets. That’s the good business. The other has $20 million in assets. That’s the bad business. We can invest in the good business, we can invest in the bad business, or we can leave our money sitting in long-term bonds.

The good business is worth twice (20 percent ÷ 10 percent = 2 times) its assets, for example, 2 × $5 million = $10 million. This is because we get the same return from the long bond by investing twice as much. The bad business earning 5 percent on invested capital is worth half its capital (5 percent ÷ 10 percent = 0.5 times). We calculate it’s worth 0.5 × $20 million = $10 million because we can get the same return from the long bond—$1 million—by investing half as much. Both businesses are worth $10 million. (And both have the same price-to-earnings (PE) multiple: 10 times.) Graham might have preferred the bad business at half its tangible asset value. But Buffett prefers the good business at twice its asset value.

Growth. Each dollar of profit reinvested in the good business is worth 200 cents on the dollar in business value (20 percent ÷ 10 percent = 2 times). Let’s say the good business reinvests all its $1 million in profit and keeps up its 20 percent profitability. The next year, it will earn $1.2 million on $6 million in capital. Applying the same multiple, it is worth $12 million. Last year, it was worth $10 million. The $1 million reinvested in the business is worth $2 million in business value. Next year, it will be worth $14.4 million and so on. Contrast this with the return to the owner of the bad business. Each dollar reinvested there becomes fifty cents on the dollar in business value (5 percent ÷ 10 percent = 0.5 times). The bad business chews up half of any dollar invested in it. How?

Let’s say the bad business reinvests all its $1 million in profit and maintains its profitability. The next year, it will earn $1.05 million on $21 million in capital. Valued the same way, the business is worth $10.5 million, just $500,000 more than the last year. The $1 million reinvested in the bad business is worth just $500,000 more in business value. It turned $1 in profit into 50 cents in value. Its growth destroyed value. This is the most surprising result of Buffett’s theory of value. Not all growth is good. Only businesses earning profits better than the rate required by the market should grow. Businesses with profits below that rate turn dollars in earnings into cents on the dollar in business value. The owner of the good business wants the business to reinvest and grow because that growth is profitable. The owner of the bad business wants all the earnings paid out because the growth destroys value.

For a business to be worth more than its invested capital, it must maintain a profit greater than the market requires. In our earlier example, the market required 10 percent. For most businesses, high profits aren’t sustainable because they attract competitors. While they may earn more over a short time, most businesses will only earn a market return—say 10 percent—on average over the full business cycle.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful worldwide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

In his Berkshire letters, Buffett has written a lot about moats. Buffett wants special businesses with a moat that resist mean reversion. He calls these “economic franchises.”

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

we spend $10 million buying the company that owes $5 million in debt, we now own a company with $5 million in debt. We have to service the debt. What we can take out of the company will be cut by the cost to carry the debt until we pay it off. What about the company with $5 million in cash? If we spend $10 million buying that company, we can immediately use the cash and any profits. The company only cost us $5 million because we got the cash back.

How would the enterprise value treat these two companies? The enterprise value penalizes the company with debt by adding the debt onto the market cap. It rewards the company with cash by taking away the cash from the market cap. The company that owes $5 million in debt has an enterprise value of $15 million ($10 million in market cap + $5 million in debt). The company with $5 million in cash has an enterprise value of $5 million ($10 million in market cap – $5 million in cash).

The enterprise value includes two other important costs that are like debt: preferred stock and minority interests. Preferred stock is stock that pays its holder a preferred dividend. (It is preferred because it is paid before the common stock dividend and has some other rights the common stock doesn’t have. If the company doesn’t have enough money to pay both, it can only pay the dividend on the preferred stock.) It is like debt because the dividend is fixed and must be paid regularly, just like interest. The enterprise value penalizes companies with preferred stock by adding the preferred stock on to the market cap. A company with a $10 million market cap and $10 million in preferred stock has an enterprise value of $20 million ($10 million + $10 million = $20 million).

A minority interest is a small stake in a company’s business owned by someone else. If we own all of a company and someone else owns 10 percent of the business, we only own 90 percent of the business. To own all of the business, we have to negotiate with the other party to buy out his or her minority interest. Enterprise value treats the minority interest as another debt. It must be paid by an acquirer of the whole company, just like debt or preferred stock.

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The market is telling stocks with negative enterprise values the business is worth less than nothing. If you buy a stock with a negative enterprise value, you are being paid—indirectly—to buy the stock. You could use the company’s own cash to buy all of its shares. In practice, stocks with low or negative enterprise values often (but not always) own bad businesses. They burn lots of cash.

As we learned with GM, an enterprise value much bigger than the market cap might suggest the company has a lot of debt (or preferred stock or minority interests). It is more expensive than it appears by looking at market cap alone. This is why we say the enterprise value is the true price of a company.

Buffett says, “The ‘operating earnings’ of which we speak here exclude capital gains, special accounting items and major restructuring charges.”[xlii] Operating earnings is the income that flows from a business’s operations. It leaves out interest and taxes. It also leaves out unusual, one-off things like gains from selling an asset or settling a lawsuit. The one-off items are left out because they won’t occur again in the future. They don’t show the usual operations of the business.

For each stock, Oppenheimer worked out the discount to its cigar-butt value. He put the stocks into five groups, from the most undervalued to the most expensive. The most undervalued group beat the next group and so on. The most expensive group had the lowest returns. The most undervalued group beat the most expensive group by more than 10 percent a year. Oppenheimer’s second finding is his most interesting one. He split the stocks into two groups. One had only profitable stocks, and the other, only loss makers. Oppenheimer found the loss makers beat the profitable group. His third finding is also interesting. He split the profitable group again. The first group was comprised of dividend-paying stocks. The second group paid no dividend. Oppenheimer found the stocks that didn’t pay a dividend beat the ones that did.

We expect to find the wider the discount to value, the better the return. The other findings are unexpected. But both fit our theory of mean reversion. Mean reversion pushes up the beaten-down prices of undervalued stocks. It pushes up beaten-down businesses, too. The key to maximizing returns is to maximize our chance at mean reversion. That means maximizing the margin of safety. We want the most undervalued stocks. And we want to make sure they survive to mean revert.

We find the margin of safety chiefly in the discount to value. But it is also a test of the balance sheet and the business. Here are three rules covering the margin of safety:

Companies that own science experiments or toys in search of a business model are for speculators. But weak current profits in a stock with a good past record creates a good chance for deep-value contrarians to zig.

Mauboussin showed how unusually high or low profits trend toward the average by tracking one thousand companies from 2000 to 2010. He ranked the businesses on economic profit—how wonderful each was—in the year 2000.[1] He put them into five groups. The top group was the most profitable. These were the great businesses. He put the bad businesses in the bottom group. These, on average, lost money. The chart below shows the results. For each of the five groups, there is a clear trend toward average profits. The highly profitable companies become less profitable. The loss makers lose less money. All trend toward average profitability.

The reason great businesses become average businesses is mean reversion. Things go back to normal. It means profits move back toward the average over time. A great business is an outlier. It is more profitable than average. Over time, competitors eat away the unusually high profits until the business earns average profits. This also happens to bad businesses, which are less profitable than average. Over time, competitors leave the industry until the businesses that stay earn average profits. This is the machinery of mean reversion. Some businesses do keep up oddly high profits. Mauboussin found a tiny handful of stocks kept high profits from start to finish. But he could not find the reasons why. And he couldn’t find the things that predict which businesses will keep up high profits. All he could say for sure is that some businesses stay highly profitable, while most go back to average. Warren Buffett can pick the needles from the haystack. He can find these companies with “moats” that protect them from competitors. Without the moat, competitors storm the gates and push the high returns back toward the average. Few companies have a moat. Even most seemingly great companies don’t have one. For this reason, most highly profitable companies see profits fall over time.

Stocks with rising profits get expensive because investors expect the profits to keep going up. And stocks with falling profits become undervalued because investors expect the earnings will keep falling. In other words, investors don’t expect profits to mean revert. But they’re wrong. Mean reversion is the likely outcome.

The chart shows the change in earnings per share for the undervalued and expensive stocks in the three years leading up to the date they’re picked.

Stunning. After they were picked, the profits of the undervalued stocks went up more than expensive stocks. The undervalued stocks’ earnings rose 24 percent in the next four years. (The chart is incredible evidence of mean reversion in earnings.)

The undervalued stocks also delivered better stock price returns. They beat the market by 41 percent over four years. Meanwhile, the stocks in the expensive portfolio lagged the market by 1 percent. These are striking results.

Five years later, analyst Michelle Clayman took another look at the stocks Peters branded excellent. She found most of the businesses had weakened. The high growth and profits had disappeared. In fact, most of the stocks were no longer excellent by Peters’s own rules. The reason? Mean reversion. Competition had pushed the high profits and growth rates back to the average. She said:[xlvii] In the world of finance, researchers have shown that returns on equity tend to revert to the mean. Economic theory suggests that markets that offer high returns will attract new entrants, who will gradually drive returns down to general market levels.

Using the same rules as Peters, Clayman went “in search of disaster.” She created a portfolio of unexcellent stocks. The table below shows Clayman’s unexcellent stocks beside a new group of excellent ones picked using Peters’s rules.

The excellent stocks were much better than the unexcellent stocks on every measure but one: valuation. Growth was higher for the excellent stocks at 22 percent per year. The unexcellent stocks grew at just 6 percent per year. The excellent stocks also had a better return on equity: 19 percent. The unexcellent stocks returned just 7 percent. (Remember, high return on equity is what makes businesses “wonderful.”) If you only looked at asset growth and return on equity, you might expect the excellent stocks to beat the unexcellent stocks. But Clayman’s excellent stocks were undervalued, and the excellent stocks were expensive. Clayman’s unexcellent stocks traded at 0.6 times book value. Peters’s excellent stocks traded at 2.5 times book value. In other words, the unexcellent stocks were fair companies at wonderful prices, and the excellent stocks were wonderful companies at fair prices. Which stocks were the better investment? In 2013, Barry B. Bannister tested Clayman’s unexcellent stocks from June 1972 to June 2013. Bannister found the unexcellent stocks beat the excellent stocks and the market by a wide margin. The unexcellent stocks averaged 14 percent per year, while the excellent stocks returned only 10 percent per year. Over the same time, the market averaged 11 percent.