INVESTMENT MADNESS

INVESTMENT MADNESS

TIM KELLEY March 16, 2015 

Here’s a question for you: what kind of business becomes more attractive as an investment proposition the more expensive it becomes?

The answer – apparently – is just about any business that has a strategy of acquiring other businesses.

Here’s how the logic works. Suppose you are the CEO of a company whose shares trade at a price/earnings of say 20x. That’s a robust multiple and demands a certain amount of growth. If your business doesn’t have the necessary organic growth, you will need to deliver the expected growth via acquisition. The good news is that you can buy companies in the same line of business from private sellers, and the multiples paid in the private market are much lower than 20x; perhaps even in the single digits.

This difference in multiple means that you can issue your own shares to acquire the privately held businesses, and achieve an automatic Earnings Per Share (EPS) uplift. The earnings attached to the shares you issue (at 20x) are much lower than the earnings you acquire in return, and so by the magic of arbitrage, your shareholders have achieved earnings (and presumably value) uplift.

Some acquisitions create value through synergy benefits, but for this strategy it is probably better to avoid that sort of thing. Integrating the acquired businesses and extracting the synergy benefits is troublesome, and likely to distract you from the main game. You are probably better off focusing on acquisitions that don’t require much integrating. That way you can do more acquisitions in a given space of time, and ….. achieve more EPS uplift!

This is advantageous for your strategy, as faster EPS uplift will justify a higher multiple being ascribed to your shares, and this in turn will increase the ratings differential between your shares and the businesses you are acquiring. A higher rating means a more magical arbitrage value.

In this way, you should be able to see that the more expensive your company’s shares become, the more effective your growth strategy becomes, and the whole thing becomes a kind of virtuous cycle.

…except that the logic is a tiny bit circular.

If for some reason your ratings were to fall, or private acquisition targets at low multiples were to become scarce, the whole charade might just start to unravel in the same way that it came about. A declining share price could wipe out the value creation potential of your strategy and justify an ever decreasing share price.

Here’s my tip: if you see a broker finding virtue in an elevated price/earnings multiple by pointing out that it facilitates EPS accretive acquisitions, it may be wise to count the seats between you and the exit row.

Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. 


http://www.montinvest.com/