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

by Tobias E. Carlisle

The reason the unexcellent stocks beat the excellent stocks and the market? Mean reversion. According to Bannister:[xlviii] In theory, high returns invite new entrants that drive down profitability, while poor returns cause competitors to exit, as well as lead to potential new management or acquisition by a competitor or financial buyer. The excellent stocks lagged because their businesses worsened. The profitability and asset growth trended to the average. The businesses of the unexcellent stocks also worsened but not as much as the excellent stocks. Clayman’s unexcellent stocks beat the market because the discount between price and value closed. In other words, the price-to-book values went up.

Profitable industries attract competition. The same forces push out competitors in loss-making industries. For this reason, wonderful businesses tend to be fair investments, and fair businesses tend to be good investments. Wonderful stocks lag because investors overestimate future growth and profits. Fair businesses beat the market because investors underestimate the change in the stocks’ price-to-value ratio. Undervalued stocks trend toward the average value, and the price rises. Expensive stocks trend toward the average value, and the price drops.

Expecting mean reversion is good investing. It works on growth rates, returns on equity, and stock prices. This leads to two rules central to good value investing:

The takeover bid put Icahn in a win-win position. On one hand, it created a price floor in the stock. Icahn could wait to see if another buyer would make a higher bid and sell to them. If no other bidder emerged, Icahn could buy the company himself. He’d get it undervalued because no one else wanted it.

Icahn was not pleased. He bought another fifty-five thousand shares and called Blasius again. This time, there would be no mistake. Icahn told Blasius he liked Tappan as a takeover candidate. He said he had made a lot of money buying undervalued stocks. Many times, a buyout had doubled the stock price. He thought Tappan was a good target for a takeover. Still, Blasius didn’t understand what Icahn was telling him. Takeovers were rare in 1977. Icahn upped his holding to several hundred thousand shares and stepped up his efforts to find a buyer for Tappan. He also continued buying Tappan stock. By late 1978, his position was big enough to file a 13D notice with the Securities and Exchange Commission (SEC). A shareholder with more than 5 percent of a company’s shares must file a 13D if they plan to take over or liquidate the company. With the filing, Wall Street finally got the news that Tappan was in play. The stock price jumped. Icahn called Blasius to tell him an acquirer had called him wanting to buy his stock for $17. It was less than the $20 Icahn wanted, but he was thinking about selling. He also asked for a seat on the board. Blasius said no. Finally, he saw Icahn was a real threat. The company moved to issue stock to block a hostile takeover. This created a problem for Icahn. The new stock would stop him from being able to use his shareholding to push for a sale of the company. He had to put a stop to the new stock issue. Icahn responded by speaking to the press. He w...

Loeb can’t bend Stiritz to his will with anything less than 50 percent of Agribrands’s shares. To buy that much stock, he would need another $190 million—$10 million more than he has in his fund. And he doesn’t want to put all his chips on this one stock, anyway. Stiritz is intent on merging Agribrands’s cashbox into Ralcorp’s businesses at a big discount to its true value. And Loeb’s little fund has a big problem.

Earlier in the year, Chapman got into a fight with another company, American Community Properties Trust. He was upset when a shakeup overseen by J. Michael Wilson, the thirty-two-year-old chairman and chief-executive son of the founder, led to a 40 percent slide in the share price.

In the letter, Chapman wrote he invested in American Community because he thought it was a “highly undervalued microcap company.”[liii] (A microcap is a tiny company when measured by market cap.) The shakeup was supposed to boost the price of the shares. Instead, the stock had almost halved.

Chapman’s letter worked. He publicly shamed Wilson and American Community into selling assets and paying down debt. American Community also started paying a dividend. Later, when asset sales slowed, Chapman started phoning Wilson again. His first seven phone calls were ignored. When he finally got through, Wilson told Chapman, “You’re a [expletive] pain in the ass, and we don’t want to talk to you.”[lv] Chapman put the phone call in another SEC filing, which attracted a lot more attention from the media. The result? Wilson and American Community again sped up its sales. The stock soared. Chapman’s letter-writing campaign was a blunt instrument, but it got the job done. It attracted attention from the media and the market, and the stock jumped. Loeb figures it’s just what he needs. He buys enough stock in Agribrands to push him over the 5 percent level. Now he can file a 13D with the SEC.

On December 4, 2000, three months after Loeb sends his letter, Agribrands announces that it will not sell to Ralcorp. Instead, Cargill, a privately owned processor of feed and agricultural products, will be the bidder. The price? $54.50 per share, $15.50 and 36 percent more than Ralcorp offered. It is a huge gain for Loeb’s second-biggest holding. And it makes Loeb infamous.

The PE multiple for Apple was 14 ($500 billion ÷ $37 billion = 14 times). This is low for a good business. The PE multiple of the ten-year treasury bond was 33 times (1 ÷ 0.03). The ten-year treasury bond is an alternative investment to Apple. We can invest in the ten-year treasury at 33 times or Apple at 14 times. Apple is less than half the PE multiple of the ten-year treasury. It is the better bet.

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Einhorn noted that to work out the value this unlocks, we have to guess how much value the market already places on Apple’s cash. If the market gives it no credit and it returns all its cash, then the cash returned is found value. This means the dividend unlocks the whole $150 billion or $20 per share. This might occur if the return on assets is boosted to more than 83 percent ($50 billion ÷ $60 billion). Profitability like that justifies a PE multiple of 14 times or higher. In that event, the market cap would stay unchanged at $500 billion. Shareholders get $150 billion and keep stock with the same market cap, $500 billion. If the market already gives Apple some credit for the cash, the amount unlocked would be cut. Einhorn wrote:[lxiii]

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There is no way to know for sure how much credit the market gives, so there is no way to know how much value will be unlocked. But the range is no less than zero and no more than [the value of the cash distributed].

you want the market return, buy the market. If you want to beat the market, you must do something different. That means buying only undervalued stocks, or concentrating. The trade-off for concentration is twofold: Concentrated portfolios tend to be more volatile than the broader stock market. This means they move around more, both up and down. Good days for the market can be great days for the portfolio. Bad days for the market can be terrible days for the portfolio. Concentrated portfolios don’t track the market. This is known as tracking error. It means concentrated portfolios can go down when the market goes up and up when the market goes down. The second kind of tracking error—portfolio up, market down—is the good kind. But you won’t notice. In practice, you’ll only notice when your concentrated portfolio is down while the market is up. Academics have found high tracking error is associated with good long-term performance. But the market can beat portfolios of undervalued stocks for a long time. Tracking error won’t feel good then. No one said it would be easy. Zigging is hard. Our guts scream at us to zag with the crowd. We know we should zig. But undervalued stocks are hard to buy. They own bad businesses. The growth has slowed, and the profits are falling; they’re losing money, or they’re headed to liquidation. That’s why they’re undervalued.

Value is more important than the trend in earnings. Undervalued low- or no-growth stocks beat expensive high-growth stocks and by a wide margin. Mean reversion pushes up undervalued stocks and pushes down expensive ones. Undervalued low- or no-growth stocks beat undervalued high-growth stocks. We expect undervalued high-growth stocks to beat undervalued low-growth stocks. We assume high-growth value stocks are good stocks at bargain prices. But the data show mean reversion acts on growth, too. It pushes down high-growth stocks and up low- or no-growth stocks.

Undervalued low-profit stocks beat undervalued high-profit stocks. Mean reversion pushes down on high profits and up on low or no profits.

Highly profitable stocks only beat the market if Buffett’s moat protects the profits. Without the moat, highly profitable stocks will get beaten up by the competition. Mean reversion acts on profits to drag down winners and push up losers. Investors should use some common sense and natural skepticism about profit charts that march all the way to heaven. It is a rare business that can resist competition. And such businesses are hard to identify. Buffett’s great skill has been to find those with defensible moats, which are his wonderful businesses. For those of us without Buffett’s talent, the more undervalued the stock, the better. This is contrarian investing. This is value investing.

How do we look past the falling stock prices, the losses, and the crisis? We know undervalued stocks beat the market. But we get stuck on the bad headlines. We want to follow the crowd far away from these stocks. Our gut fails us here.

This is the broken-leg problem. Suppose we have a rule for predicting whether John and Jane go to the movies together. If we know John has a broken leg, can we ignore the simple rule and make our own decision? The argument is the simple rule will get the question wrong because it doesn’t know John’s leg is broken. Surely, we can include this data to decide that John and Jane will stay home. Won’t that make our prediction more accurate? The studies find that it does not. The reason is we find more broken legs than there are. We make our own decisions too often, including too much irrelevant data. This is true for companies with bad businesses, slowing growth, falling profits, or losses. As a portfolio, fair businesses at wonderful prices beat the market. But these companies look like they have broken legs. They have lots of reasons to override the simple rule and make their own decisions. We are better off if we just follow the simple rule.

Both are equally valid approaches, but the business owner is by far and away the more difficult of the two. Most investors will be better off as quantitative investors. Consider this: most professional investors can’t beat the market. (And when we say most, we mean 80 percent of professional investors.) The reasons most people lag the market: cognitive biases and behavioral errors.

Greenblatt concluded, “I don’t know if that’s good news, but I like the message it appears to send—simply, when it comes to long-term investing, doing ‘less’ is often ‘more.’ Well, good work if you can get it, anyway.”

Here’s why: the only way to get a good price is to buy what the crowd wants to sell and sell what the crowd wants to buy. A good price implies a lopsided bet: a small downside and a big upside. The downside is small because the price already assumes the worst-case scenario. This creates a margin for error. If we’re wrong, we won’t lose much. If we’re right, we’ll make a lot. An upside bigger than the downside means we breakeven, even if we err more often than we succeed. If we manage to succeed as often as, or more often than we err, we’ll do well.

The bigger the discount to value the better the return. This is true in the United States, United Kingdom, Europe, Africa, Asia, Australia, and New Zealand. It’s true in developing and emerging markets. It’s true globally. Deep discounts and good returns go together.

First, the greater the company’s discount to its value, the safer the purchase. A wide discount allows for errors and any decay in value. This is the corollary to the last rule that the biggest returns flow from the biggest discounts. It breaks the received wisdom of the market and academia that higher returns mean more risk. Here, the greater the margin of safety, the higher the returns and the lower the risk.

Finally, the company should own a real business. The business should have strong operating earnings with matching cash flow. Matching cash flows ensures the accounting earnings are real and not merely the figment of a clever embezzler’s mind. We look for signs of earnings manipulation. 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 offers a good chance for mean reversion in those profits.

First, a shareholder has rights as an owner of a company. Shareholders exercise those rights by voting at meetings. Second, shareholders should pay attention to everything a company owns. That includes its business and its assets, chiefly its cash.

Many investors follow profits—the fruits of the business—but ignore assets on the balance sheet. They ignore cash. A seemingly poor business with a strong balance sheet could represent hidden value. The asset value offers a free call option on any recovery in the business.

The secret to avoiding these errors is to use a set of simple, concrete rules. Ideally, we should write them down and strictly follow them. Simple, concrete rules are testable. They should be back tested and battle tested. The back test makes sure the rules work over historical data sets, ideally in different countries and stock markets. The battle test makes sure the rules work in practice. No strategy has ever failed in theory. Almost all have failed in reality.

you want to match the market, buy the market. If you want to beat the market, you must do something different. That means buying only the best ideas, or concentrating.

The effects of compounding take a long time to become observable.

Taxes and fees are hidden enemies of long-term compounding.

Value investing is a logical, time-tested investment method. The best value investors zig while others zag. They maximize their margin of safety and minimize their costs and taxes. They treat high growth and profits skeptically. And they assume their calculations and thinking are wrong. Skepticism, humility, and low costs maximize our chances of surviving. With luck and time, we can beat the market.

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