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

by Tobias E. Carlisle

Value investors take the other side of this trade. Where the stock price discounts even the worst-case scenario, the worst-case scenario can lead to market-beating returns.

The Acquirer’s Multiple buys stocks with mixed profits; some are highly profitable, others break even, and others lose money. It relies on the price mean reverting to the value and the businesses improving.

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.

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.

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 2005, GM had a market cap of $17 billion and debt of $287 billion. If we only looked at GM’s market cap, we would have missed its huge pile of debt.

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.

Why do fair companies at wonderful prices beat wonderful companies at fair prices? Because great businesses don’t stay great. They only look great at the top of their business cycle. Mean reversion pushes great business back to average.

A tiny handful keep profits up, but we don’t know how they do it. We can’t tell the few that can maintain high profits from the many that become average. It’s random chance.

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.

For those of us without Buffett’s talent, the more undervalued the stock, the better. This is contrarian investing. This is value investing.

Meehl means this: for lots of problems, simple rules make better forecasts than experts. This is the Golden Rule of Predictive Modeling.