This blog has never been designed to be an online literary salon, but I believe exceptional pieces of work are worth mentioning, especially in the area of finance & investing where mediocre quality and fuzzy ideas are too often the norm. I would be lying if I wrote that I spontaneously came up with this find; in reality a fellow investor highly recommended it to me. Let us end the suspense here: the book is called Quality Investing: Owning the Best Companies for the Long Term, was written by a trio (Lawrence A. Cunningham, Torkell T. Eide and Patrick Hargreaves) and has been available for purchase since January this year.
“Lawrence A. Cunningham has written a dozen books, including the Essays of Warren Buffett: Lessons for Corporate America”. The very first few words set the tone for the rest of the reading: quality investing is “a way to pinpoint the specific traits, aptitudes and patterns that increase the probability of a particular company prospering over time – as well as those that decrease such chances”. To anchor the concepts into reality the book contains more than 20 recent case studies), Cunningham partnered with two investment managers from AKO, a London-base hedge fund created in 2005.
Books dedicated to investing and corporate performance improvement invariably tackle the investment process from a narrow angle. A large number of those address financial statement analysis and intend to limit the corporate performance assessment process to the analysis of CAGRs and ratios. And yet, as rightly pointed by Cunningham and his co-authors, “growth forecasts and valuation measures […] are riddled with innumerable obscure and subjective judgements, ranging from accounting line items to appropriate discount rates“. Other books have conversely tried to holistically describe the various parameters of corporate strategy and business operations, an unreachable target that ultimately produce cumbersome and confused compendium of more or less interesting ideas. The fact that Cunningham & al. managed to summarise a range of aspects into a well-structure and digest (less than 200 pages) book should be regarded as a major achievement in that respect.
To be more specific, their work is structured in four parts, from the basic ‘building blocks’ of quality investing (part 1 which includes a word on my favourite vice, aka dividends and share buybacks) to typical ‘patterns’ that distinguish quality companies from their competitors (part 2) to common ‘pitfalls’ which may mislead the investor (part 3) and to the ‘implementation’ of such quality investment decisions (part 4).
The style is succinct, direct and easy to understand. No word seems redundant and the alchemy between the three authors (one professor, one former strategy consultant and one former investment banker) is unquestionable. The book will not provide you with a ‘plug-and-play’ process to successful investment – all books trying to do so have failed – but instead lists a series of considerations that you should include in your thinking before betting on a business.
Actually, for less than £25 purchasing this book is probably an easy ‘quality investment’ decision to be made.
My next post will partly relate to this notion of ‘quality investing’. In the meantime, you can watch Cunningham discuss his passion for Berkshire and investment strategies in the video below.
I have finished writing another post for Movemeon, the second one of my ‘PE series’. This one deals with the best moments of a consulting career to transition to private equity – the first one, published a couple fo weeks ago, dedicated to the various types of private equity fund.
After decades of cautious suspicion towards technology-related stocks (with the notable exception of IBM), Warren Buffett has crossed the Rubicon and is now an Apple shareholder. The news clearly took the financial community by surprise: Apple’s stock jumped by 2% in pre-market trading after the announcement (indicated by a green arrow in the chart below) and is now up 4% compared with last week.
Not only does the move surprise given Mr. Buffett’s historical ‘tech-adverse’ inclination but this move also contradicts a statement he made no earlier than 4 years ago, saying that he would “not be able to value [Apple’s] stocks“. Last but not least, Berkshire is investing at a time when another famous investor, Carl Icahn, has taken the opposite direction by offloading his $4bn stake last month.
Why has Warren turned round? We cannot accuse Berkshire of trying to benefit from the recent air pocket Apple went through which we discussed on this blog three weeks ago, since the stake was built throughout the first quarter. Nor can we assume that Mr. Buffett will be able to impose his views on Apple’s management: his stake is important in nominal terms ($1bn), but only represents 0.2% of the total shareholder structure.
In my view, the reason lies in another factor we have underlined. According to our EV/EBITDA benchmarks (reproduced below) the market is primarily viewing Apple as a hardware company at present, which is understandable given the share of revenues generated by devices such as the iPhone and, to a lesser extent, the iPad and the iPod.
And yet, Apple is trying hard to get out of the generally slow-growing, low-margin hardware trap where it can be considered as an alien – but for how long? – by investing part of its massive war chest into promising ventures, both internally – iTunes and, more recently, iCloud – and externally – the $1bn stake taken in Chinese ride-hailing app Didi Chuxing is the most significant to date.
If Apple manages to grow the seeds it has been planting over the last few years and to convince Wall Street that it has now become a credible player in the ‘virtual’ space alongside other tech behemoths such as Google, Amazon or Microsoft, it will be able to command a higher valuation multiple which will ultimately lift its stock price. And the ‘Oracle of Omaha’ will have won his bet (once more).
I thought today’s economic environment was perfect to reread Irrational Exuberance, the book written by Nobel Prize-winning Yale University professor Robert Shiller. Prof. Shiller made himself known to the general public by predicting the ‘dot-com’ bubble in the 2000s as well as the housing market collapse in 2007-2008. Coincidentally, no later than last year Prof. Shiller granted us with a third revised edition of his book which analyses the two aforementioned events to identify behavioural patterns leading to market instabilities.
Chapter Four, ‘Precipitating Factors: The Internet, the Capitalist Explosion, and Other Events‘, lists and discusses the triggering factors that were specific to the economic context at that time. The section entitled ‘Twelve Precipitating Factors That Propelled the Late Stages of the Millennium Boom, 1982–2000‘ resonates way too well in the light of the rise of ‘disruptive’ technologies and social media. Below are some quotes which I found particularly striking.
Because of the vivid and immediate personal impression the Internet makes, people find it plausible to assume that it also has great economic importance. It is much easier to imagine the consequences of advances in this technology than the consequences of, say, improved shipbuilding technology or new developments in materials science. [...] It could not have been the Internet that caused the growth in profits: the fledgling Internet companies were not making much of a profit yet. But the occurrence of profit growth coincident with the appearance of a new technology as dramatic as the Internet created an impression among the general public that the two events were somehow connected.
Do not get me wrong: some of the largest technology companies (by market capitalisation) completely justify their valuation because of the value they create. Nonetheless, one cannot help but think that some of the technology-related ventures created over the last couple of years (with a special attention to loss-making ‘unicorns’) were lifted by the abundance of liquidity in the market and the investors’ search for yield in a depressed environment.
New technology will always affect the market, but should it really raise the value of existing companies, given that those existing companies do not have a monopoly on the new technology? Should the advent of the Internet have raised the valuation of the Dow — which at the time contained no Internet stocks?
The impact of social media and ‘Uberisation’ still remains to be quantified, as the impact of the Internet was in the early 2000s. But here again caution is paramount. As an example, asset-light Fintech companies were expected to put the traditional banks out of business. We now see that those companies have benefited from an extremely favourable credit environment and struggle as soon as the tailwinds fade.
What matters for a stock market boom is not, however, the reality of the Internet revolution, which is hard to quantify, but rather the public impressions that the revolution has created. Public reaction is influenced by the intuitive plausibility of Internet lore, and this plausibility is ultimately influenced by the ease with which examples or arguments come to mind. If we are regularly spending time on the Internet, then these examples will come to mind very easily.
This sentence is very applicable to today’s trend. A vast majority of the successful emerging companies target the B2C market and actually very often make the ‘B’ closer to the ‘C’ by ousting intermediaries – think about Uber or Deliveroo. The change has settled in our everyday life, which makes the examples even easier to remember.
Anticipation of possible future capital gains tax cuts can have a favorable impact on the stock market, even when tax rates actually remain unchanged. From 1994 to 1997, investors were widely advised to hold on to their long-term capital gains, not to realize them, until after the capital gains tax cut.
Calls for a fiscal stimulus as a way to reinforce the already-implemented monetary ‘quantitative easing’ have been growing. Although in the UK the next budget will only affect the corporate tax rate, investors are right to believe that the fiscal burden may loosen soon on capital gains as well.
Although there is no doubt at least some truth to these theories of the Baby Boom’s effects on the stock market, it may be public perceptions of the Baby Boom and its presumed effects that were most responsible for the surge in the market.
Structural drivers such as demographics are indeed among the most popular discussion topics when it comes to predict the outlook of both the stock and the housing markets. Prof. Shiller nonetheless warns us that our (sometimes) self-fulfilling anticipations and expectations may actually be stronger than the real effect.
As further evidence that the media growth was boosting the stock market, we now know that after the peak in the market in 2000, business reporting took a major hit in reaction to declining public interest. Hip business magazines like Red Herring, the Industry Standard, and others went out of business.
As sole writer of this blog I have to plead guilty. As many other media, I have probably paid a disproportionate amount of interest to the evolution, past and future, of the housing market.
In a non-experimental setting, where people’s focus of attention is not controlled by an experimenter, the increased frequency of price observations may tend to increase the demand for stocks by attracting attention to them. [...] The rise of gambling institutions, and the increased frequency of actual gambling, had potentially important effects on our culture and on changed attitudes toward risk taking in other areas, such as investing in the stock market.
Our environment, including social media conversations, provides us with many opportunities to be part of the stock market ‘game’ and many platforms have leveraged the parallel with gambling, making their platforms increasingly entertaining.
In a survey of home buyers in 2004, Karl Case and I asked: “Do you worry that your (or your household’s) ability to earn as much income in future years as you expect might be in danger because of changes in the economy (someone in China competing for your job, a computer replacing your job, etc.)?” Nearly half of our 442 respondents (48%) said they were worried. Some of them said that one motivation for buying their house was the sense of security that home ownership provides in the face of the other insecurities. [...] One might call this a “life preservers on the Titanic theory.” When passengers on a ship think the vessel is in danger of sinking, a life preserver, a table, or anything that floats may suddenly become extremely valuable, and not because these assets have changed their physical attributes. Similarly, at a time when people are worried about the sustainability of their labor income, and there are not enough really good investment opportunities, they may tend to bid up prices of all manner of existing long-term assets in their efforts to save for the dangerous lean years seen ahead. They may not manage to save more in real terms. They may hold such assets even if they now believe the assets are overpriced and in danger of losing value in the future.
The sense of geopolitical and economic insecurity remains persistent – today a poll revealed that 86% of French people believed that the situation “had not improved for the French population in general”. In that context individuals tend to rely on ‘safe’ investments such as real estate and bonds, despite the very poor returns offered by the latter.
Will we witness another 2000-type market crash in the short-term? I do not believe so. However, I do think that the Central Banks’ decision to open the liquidity tap to an extent never been witnessed before has led investors, i.e. the general public, to increasingly disconnect their thinking from the real fundamentals of our economy. The way the two converge again will tell us whether we are heading towards a ‘soft landing’ or a ‘bubble burst’.
A couple of months ago the Boston Consulting Group released an interesting report on the ‘Power of Buy and Build‘ in Private Equity deals. To quote the first sentence of the report, “buy-and-build deals, in which private equity firms introduce operational improvements to their portfolio companies through add-on acquisitions, are now the PE value creation strategy of choice“.
Undoubtedly buy-and-builds are on a roll. In 2000, only 20% of private equity deals were including inorganic growth transactions. In 2012, that share rose to 53%. Bain & Company reported that a record $267bn worth of add-on acquisitions were completed by PE sponsors in 2015. What is more doubtful, though, is the fact of considering these buy-and-builds as the “PE value creation strategy of choice”. Based on my experience of private equity as well as existing academic literature, here are 6 reasons why:
My first remark involves the very definition of ‘buy-and-build’ “in which private equity firms introduce operational improvements to their portfolio companies through add-on acquisitions”, according to the report. Although post-merger integration phases can sometimes trigger the implementation of a wider operational improvement plan, enhancing a given company’s processes can most often be done independently of any acquisition activity.
2. The report seems to overlook the distinction between ‘value creation’ and ‘value capturing’. As explained by Berg and Gottschalg in their paper Understanding Value Generation in Buyouts, value creation “is directly linked to a fundamental change in the financial performance of the target organisation” while value capturing “reflects the fact that [an increase in the equity value of the company] can occur without any change in the underlying financial performance of the business”. Value generation is simply obtained by summing up the two components. The BCG report states that multiple arbitrage is the key driver of superior performance behind buy-and-build deals. And multiple arbitrage is typically one of the value generation drivers that cannot be considered as value creation but value capturing.
3. An increase in multiple is not simply attributable to “increased expectations of profit growth”, as mentioned by the report, but also reflects the dynamics of the sale process. An asset coveted by a larger number of buyers will likely sell at a higher price. Bain’s Private Equity Global Report 2016 is in that sense right to state that “by adding on enterprises in the same or related business to a portfolio holding, GPs can target companies that are often too small to attract the attention of big corporate acquirers and can be bought at reduced prices” – we could extent the argument to the competition coming from mid to large-cap PE funds which benefit from an extensive sourcing network and an abundance of liquidity.
4. For a given average financial performance level, more stable cash-flows will often lead to a higher multiple. Meeting the debt schedule is indeed a key requirement for any PE-owned company. This enhanced cash-flow stability can be achieved by widening the ‘business base’ and developing new (adjacent) business lines, entering new geographies etc. If the PE owner decides to combine two ‘narrow base’ businesses, it can create a merged ‘wide base’ business which will benefit from a massive multiple uplift without having delivered any value, simply on the basis of unproven and undelivered potential growth. The uplift will be even more significant the smaller the standalone companies originally are.
5. Furthermore, the BCG report concludes that “deals that include one or two add-on acquisitions outperform both standalone deals and those that include more than two acquisitions”. This conclusion holds if we consider IRR as the only performance metric, but can be challenged if we take the money multiple (‘MoM’) into consideration as well. Indeed, each additional add-on acquisition may enable the PE owner to capture incremental value in nominal terms, but the extra time required to complete and integrate the additional transaction may penalise the deal’s IRR. A concrete example is outlined at the bottom of this post and is a perfect illustration of the conflict which may arise between the two concepts and ultimately between the main stakeholders – GPs are incentivised to sell as soon as the multiple arbitrage related to the first add-on acquisition has cristallised whereas LPs would be financially better-off by waiting for another acquisition. Historically, IRR was the key measure to ensure that investors were directing their money towards the most profitable investments at any point in time. Today, with limited growth, negligible inflation and sometimes negative interest rates, we could wonder if IRR has not actually become a secondary indicator – but we will pursue this debate in another post.
6. Last but not least, when we come back to the true definition of ‘value creation’ and when we look at the chart above, we could actually conclude that add-on acquisitions deliver almost no incremental value – ‘synergies’ – and potentially destroys some. In a standalone deal, the IRR attributable to operational improvement is 12.9% (7.4% + 5.5%) whereas the buy-and-build deal only delivers 12.2% (5.0% + 7.2%). In his book Thinking: Fast and Slow, Nobel Prize Daniel Kahneman – whom we have already talked about in another post – has identified a couple of unconscious phenomenons underpinning our ‘overconfident’ self: ‘planning fallacy’ is the tendency to take on a risky project confident of the best case scenario without seriously considering the worst case scenario and our ‘optimistic bias’ gives unwarranted optimism which does not calculate the odds and therefore could be risky.
The conclusion is simple: buy-and-builds are not value creation processes but are sources of value captured by private equity funds as a reward for consolidating markets and making companies more financially robust; an arbitrage mechanism rather than a pure operational effectiveness program.
Example of additional add-on investment with mixed effect on IRR and MoM
We suppose here that the Enterprise Value (‘EV’) perfectly corresponds to the price the PE owner can buy or sell companies for. The year count starts at 0.
The MoMs and IRRs are as follows:
As a consequence, while investors would ultimately make a larger nominal profit under scenario 3, the IRR, which drives GPs’ behaviour (and carried interest), is actually lower.