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

by Tobias E. Carlisle

Because the markets are ruled by a powerful force known as mean reversion: the idea that things go back toward normal.

Undervalued, out-of-favor stocks tend to beat the market. Glamorous, expensive stocks don’t. Fast-growing businesses tend to slow down. Highly profitable businesses tend to become less profitable. The reverse is also true. Flatlining or declining businesses tend to turn around and start growing again. Unprofitable businesses tend to become more profitable.

The consensus thinking is generally wrong. If you go with a trend, the momentum always falls apart on you. So I buy companies that are not glamorous and usually out of favor. It’s even better if the whole industry is out of favor.

You have to be an independent thinker in markets to be successful because the consensus is built into the price. You have to have a view that’s different from the consensus.

“Value investing is at its core the marriage of a contrarian streak and a calculator.”10 Klarman is saying that we should do some work. It’s not enough that the crowd doesn’t want a stock. We should figure out if we do. For that, we look at the company’s fundamentals.

We should know what the company does. What is its business? How does it make money? We should know what it owns. What are its assets? What does it owe? We should know who runs it and who owns it. Is management doing a good job? Are the big shareholders paying attention?

Undervaluation results from flatlining growth, falling profits, losses, or looming failure. Why buy a company with a failing business, even if it is undervalued?

There are three reasons: It might have valuable assets. The crowd often sells a stock based on its business alone, ignoring its cash and other assets. Many seemingly scary, bad, or boring businesses turn out to be less scary, bad, or boring than they seem. Poorly managed companies attract outside investors who might buy them or turn them around. This is what private equity firms and activists do for a living. But shareholders don’t have to wait on other investors. They have rights as owners, and they exercise those rights by voting at meetings. With enough votes, shareholders can change a company’s bad policies.

Companies become undervalued because businesses hit a bump in the road. The

A seemingly poor business with a lot of asset value can be a good bet. If the business improves, it can be a great bet.

The reason is a powerful market force known as mean reversion, a technical name for a simple idea: things go back to normal.

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.

A moat is something that allows a business to beat its competition.

A patent, for example, is a moat. A patent is the sole right to make an invention. If you have one, you can stop everyone else from making your invention for twenty years. If no other business can copy the invention, the owner of the patent has a monopoly and can charge whatever price maximizes its profit.

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:

Only a few businesses have a moat. Most don’t. It can be hard to tell a business with a real moat from one that is at the peak of its business cycle. A moat is no guarantee of high profits. Coke’s brand allows it to sell its cola for more than other colas. But if tastes change to other sodas, or water, Coke’s profits will fall. Moats don’t last forever. Newspapers used to have a moat. If you wanted to advertise in a city, you advertised in the local paper. There was no other way. The Internet has changed that relationship. Now, you might advertise with Google or Facebook.

“cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit,” he said.15 Sanborn Maps had been a classic example of a cigar butt in 1958. In 1959, he found another one, Dempster Mill Manufacturing Company.

It made its windmills faster than it could sell them and its inventory had grown too big compared to its small business.

Investors looked at Dempster’s low profits and sold it down to half the value of its working capital, which included its bloated inventory.

Buffett estimated its net working capital—cash, accounts receivable, and inventory minus all liabilities—at around $35 per share. He guessed the tangible book value—the amount of physical assets owned by the company free of any liabilities—to be much higher, between $50 and $75 per share. He could buy the stock for $16 per share. The business would never be very ...

He said he split his investments into three groups: Generals Workouts Control situations Generals were simply undervalued stocks. Buffett bought the stock at a big discount to its value and sold when the market pushed the price up to the value. The workouts were stocks on a timetable. They did not wait on market action. Some other force put these stocks on a rocket sled. That force was a corporate action, a board-level decision that delivered a big return of capital or stock buyback, a liquidation, or a sale of the business.

If a general—one of Buffett’s undervalued stocks—stayed undervalued for too long, it might become a control situation. Buffett would simply keep buying until he owned enough to control the company. Dempster started out as just another undervalued stock. When the price didn’t move, Buffett did.

If a general moved up before he got control, he sold out. If it didn’t move, or fell, he bought more. The ability to get control of the company was important to Buffett because it gave him control of the stock’s destiny. Stocks either moved up or Buffett moved in and fixed them up. It worked. And it worked best in down or sideways markets. Either way, Buffett beat the market like a rented mule.

Buffett preferred to let others do the work, but he would take control if the company kept losing money. He knew the ability to take control put him into a win-win position. If the stock went up, he made money. If it went down, he bought more, fixed it up, and made money:19

“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks:”

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.

Buffett met Charlie Munger in 1959. Munger had a huge effect on Buffett’s investment style over the years. Until he met Munger, Buffett thought about valuation only in terms of hard numbers. He said he wanted the figures to hit him over the head with a baseball bat. Munger thought Buffett was too limited. Some businesses were “worth paying up a bit to get in with for a long-term advantage,” he said.22 When analyzing an investment, Munger thought more about its softer qualities. He tried to get Buffett to think about more than just the hard numbers. The problem as Munger saw it was that the stocks Buffett liked usually owned bad businesses. Munger didn’t like bad businesses. “The trick,” according to Munger, “is to get more quality than you pay for in price.”23 Buffett’s first step down Munger’s road was an investment in American Express, or AmEx, as it is known. In 1963, AmEx was pulled into the “salad-oil” fraud committed by a client, Tino De Angelis. De Angelis bought and sold soybean oil, which he stored in tanks in his New Jersey warehouse. AmEx is best known for its Traveler’s Cheques and credit cards. But it also had a smaller business issuing warehouse receipts. (The documents are proof a client owns a commodity like soybean oil stored in a warehouse.) Warehouse receipts make it possible to trade a commodity like soybean oil—sell it back and forth—without moving the physical oil. AmEx gave De Angelis warehouse receipts for the amount of soybean oil they thought was ...

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De Angelis was caught when the price of soybean oil plunged and he couldn’t pay his broker. The drop was so deep it wiped out De Angelis and his broker, too. Folks who had lent money against De Angelis’s warehouse receipts looked to AmEx to pay them back. They complained AmEx should have made sure the tanks contained soybean oil and not seawater. It was a good argument. They wanted $175 million, which was more than ten times what AmEx earned in 1964. It looked like AmEx would be wiped out, too. The market cut the stock price in half. Buffett became interested when he saw the stock price fall. AmEx was a tough stock to value. It was an insolvent lending business tangled in a fraud. Buffett wasn’t worried about the fraud or the $175 million payment. He was worried about how AmEx’s business customers viewed its credit. If they became apprehensive, they might stop taking traveler’s cheques and AmEx cards. Restaurants and small hotels could go out of business if AmEx was wiped out. If they stopped accepting the cards, AmEx was finished. Buffett was also worried that De Angelis’s fraud would stain AmEx’s brand in the minds of AmEx cardholders. If it did, people might stop using the AmEx cards. Buffett asked his broker, Henry Brandt, to find out if restaurants and other small businesses were still accepting AmEx. This was an unusual question from Buffett. He was usually only interested the hard data. Brandt staked out banks, restaurants, and hotels. Brandt delivered to Buffett a ...

The key to Buffett’s change of heart was what happened next. Over the following five years, AmEx traded up to around $185. Its business continued to grow, and Buffett’s hedge fund’s holding grew with it. Buffett sold out when he liquidated the hedge fund in 1969. After five years, the shares were up more than five times. The AmEx investment showed him Munger was onto something. Buffett knew it was worth at least $50 per share if it survived the salad oil crisis. But 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. Munger was right. A good business bought at the right price was the better investment. There would be no more hostile control situations for Buffett. The returns were higher, but the stocks were too small for his growing bankroll. And the companies didn’t grow. Buffett said,...

When Buffett heard See’s Candies was for sale, he said, “Call Charlie.”25 Munger lived in California. He knew all about See’s. He told Buffett, “See’s has a name that no one can get near in California…It’s impossible to compete with that brand without spending all kinds of money.”26 Buffett looked at the numbers. He agreed he “would be willing to buy See’s at a price.”27 The offering price was sky high. Harry See, the son of the founder, wanted $30 million for a business with just $8 million in hard assets. The extra $22 million on top of the hard assets bought See’s intellectual property—its brand, trademarks, and goodwill. And it bought a business that earned $2 million after tax in 1971. Buffett hesitated; $30 million was a lot of money. But Munger argued See’s was worth paying up for, so Buffett countered with $25 million. At that price, Buffett and Munger would pay 12.5 times See’s profits and 4 times See’s hard assets. It was a huge leap for an investor who liked to buy stocks at a fraction of hard asset value. Harry See didn’t want to lower his price, but Buffett explained that he and Munger were at the “exact dollar limit of what they were willing to pay.”28 Any higher and they would walk. See caved. On January 31, 1972, Buffett and Munger bought See’s Candies for $25 million. Why was Buffett willing to pay so much? He saw the value in See’s customer franchise. See’s chocolate was especially high quality. Chocolate lovers preferred it to candy that cost two or thre...

In the past, Buffett would have sought a lower price, perhaps a discount to the hard assets, to give a margin of safety. But See’s ability to make lots of profit on little hard assets made it worth a lot more than its hard assets. See’s high profits allowed it to grow quickly and throw off cash at the same time. But what was See’s worth? 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). The $25 million price was only about one-half to two-thirds See’s value. In this light, See’s was a bargain. There is a secret to See’s. Even if Buffett had paid full price, See’s would still have been an incredible investment. Here’s why. 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 ...

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.

The economic franchise is a special business that earns high profits. Crucially, it keeps up profits over the business cycle despite the efforts of competitors.

As Buffett quips, “When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

“I’d rather have a $10 million business making 15 percent than a $100 million business making 5 percent. I have other places I can put the money.” —Warren Buffett to Ken Chace, President, Berkshire38

The second part of Buffett’s rule is a fair price. For this, Greenblatt used what he called the “earnings yield.”39 We call it the Acquirer’s Multiple. To avoid confusion, we’ll call it the Acquirer’s Multiple here. In the next chapter, we’ll look at it in detail. It is a little like the PE multiple, which compares a company’s market cap to its earnings—its profit. The PE multiple is a great rule of thumb to figure out how cheap a company is. The lower the multiple, the cheaper the company.

For now, know the Acquirer’s Multiple measures how much you have to pay for each dollar a company makes. The less you have to pay for the operating earnings, the better the price. Let’s go back to Red Soda and Blue Soda.

Let’s put the return on equity and the Acquirer’s Multiple together. Greenblatt is looking for a stock that makes a lot of profit for each dollar invested in it. At the same time, he wants to pay as little as possible for each dollar it makes. He wants a wonderful company at a fair price. Magic Formula = Wonderful Company + Fair Price

“In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too shall pass.’”

The Acquirer’s Multiple compares the total cost of a business to the operating income flowing into the company. It assumes the acquirer can sell assets, pay out the company’s cash, or redirect the business’s cash flows.

It is a powerful tool because it reveals hidden cash and hidden cash flows. It also uncovers hidden traps and companies carrying huge debt loads.

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

Think of the enterprise value as the price you pay and operating earnings as the value you get. The lower the Acquirer’s Multiple, the more value you get for the price you pay and the better the stock. Let’s look at each of the parts: enterprise value and the operating earnings.

It is the total price an acquirer of a company must pay.

Market cap tells us how much it costs to buy all of a company’s shares. It is the number we would arrive at if we counted all of a company’s shares and multiplied it by the stock price.

Some new investors make the mistake of thinking the price of a share tells us how expensive the company is. They think a $10 share is twice as big or expensive as a $5 share. This isn’t right. Until we know how many shares are on issue, we don’t know which company is bigger or more expensive.

Enterprise Value: The Whole Iceberg

Enterprise value tells us how much it costs to buy all of the stock and all of the debt (and other things like debt).