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

by Tobias E. Carlisle

What caused the Acquirer’s Multiple to beat the Magic Formula? Mean reversion. Choosing stocks on historical profitability reduces returns. To show it, we created a new strategy that only buys stocks with the highest profits. It doesn’t look at value. We call it Pure Charlie in honor of Charlie Munger’s Poor Charlie from Poor Charlie’s Almanac.

Buying portfolios of highly profitable companies works. But it doesn’t beat the Magic Formula, which looks at value, too. Of course, looking purely for value works best. That’s why the Acquirer’s Multiple beats both.

Graham suggested investors use his cigar-butt method, the same method Buffett used in his hedge fund to find Sanborn Maps and Dempster Mills.

First, the stocks are undervalued. And the more undervalued they are, the bigger the return. Graham’s instinct about the margin of safety is right. The greater the discount, the bigger the gain.

Here are three rules covering the margin of safety: The greater the company’s discount to its value, the bigger the margin of safety. The bigger the margin of safety, the better the return and the lower the risk. A wide discount allows for the ordinary errors in calculations of value, and it allows for any drop in value. This breaks the received wisdom of the market. And financial academics ignore it. Both think higher returns mean more risk. Find a margin of safety in a company’s balance sheet. Many, many stocks have sunk due to too much debt. We need to make sure the stocks have more cash than debt or that the debt is small relative to the business. The Acquirer’s Multiple favors exactly these stocks. Find a margin of safety in a company’s business. The company should own a real business, which should have historically strong operating earnings

with matching cash flow, which confirms the accounting earnings are real. It means they are not the creation of a clever embezzler’s mind. We should also look for signs of earnings manipulation. This can be the first step down the road to fraud.

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.

profits move toward the average over time. Only some stocks avoid it, and we don’t know why. Without Buffett’s genius for business analysis, we can’t rely on a high-profit business staying that way. This is why fair companies at wonderful prices beat wonderful companies at fair prices.

Overreaction: The Profit Trend Extrapolated Too Far Investors expect stocks with profits that have gone up for a few years to keep going up. And they think stocks with a few years of falling profits will keep going down.

Mean reversion.

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.

Mean reversion means the stock prices of undervalued stocks are likely to rise over time, and the stock prices of expensive stocks fall.

This leads to two rules central to good value investing: Over time, undervalued stocks beat expensive stocks and the market. The reason? Stock prices mean revert to value. Expensive stocks go down. Undervalued stocks go up. This is why value investors like Icahn and Buffett beat the market. Returns on equity and earnings growth rates mean revert, too. High returns on equity go down. High rates of earnings growth slow. Low returns on equity rise. Low or negative earnings growth improve.

Most domestic companies and almost all foreign companies are loath to launch an “unfriendly” takeover attempt against a target company. However, whenever a fight for control is initiated, it generally leads to windfall profits for shareholders. Often the target company, if seriously threatened, will seek another, more friendly enterprise, generally known as a “white knight” to make a higher bid, thereby starting a bidding war. Another gambit occasionally used by the target company is to attempt to purchase the acquirers’ stock or, if all else fails, the target may offer to liquidate.

It is our contention that sizeable profits can be earned by taking large positions in “undervalued” stocks and then attempting to control the destinies of the companies in question by: a) trying to convince management to liquidate or sell the company to a “white knight”; b) waging a proxy contest;

c) making a tender offer and/or; d) selling back our position to the company.

Icahn’s first target was Tappan Stove Company,

Carl Icahn Taoism takeover

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.

tough. This creates a good spot for investors willing to lag over the short term. We call this time arbitrage.