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

by Tobias E. Carlisle

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. In this book, the ideas in those are simplified, summarized, and expanded.

As Klarman says, “High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen.”

AmEx’s value was not in its assets; it was in its business. And that business kept growing. Combining a growing business with a bargain price meant great returns that kept going year after year.

Buffett saw the hard assets being only as valuable as the business’s ability to profit on them. The higher the profit on assets, the higher the value of the business.

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.

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.

The Acquirer’s Multiple is the enterprise value divided by operating earnings.

Companies with enterprise values of $0 (and less) do exist. A low or negative enterprise value is a good thing to find. It means the company has little debt and lots of cash relative to the market cap.

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.

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.

Undervalued stocks trend toward the average value, and the price rises. Expensive stocks trend toward the average value, and the price drops.

Contrarian investors take advantage of mean reversion. They know undervalued stocks with low returns on equity or falling profits beat the market. They know glamor stocks with high returns and growth lag the market.

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.

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.

Consider this: most professional investors can’t beat the market. (And when we say most, we mean 80 percent of professional investors.)

Greenblatt says, “The people who ‘self-managed’ their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!”

For most industrial companies, the Acquirer’s Multiple is the best single measure of undervaluation. The Acquirer’s Multiple is a company’s enterprise value compared to its operating earnings. It is the metric private-equity firms use when buying companies whole and activist investors use when seeking hidden value.

For nonindustrial businesses like financials, such as banks and insurers, book value is the better single measure. Whatever the proxy, the goal is deep undervaluation.

The evidence shows the odds of finding the next high-growth or high-profit stock are about the same as flipping a coin. Buffett’s genius has been to identify these businesses. Mere mortals are better served buying at a steep discount to value.