Antifragility, Path Dependency, and Value Investing (Part 1)


Today I am going to do something we rarely do. I will share a large excerpt from IMA’s last quarterly letter to clients. Our quarterly letters are somewhat unconventional in that they provide an in-depth look at our investment process and explain in great detail every major decision that went into each client’s portfolio during the quarter. We are somewhat embarrassed about the length of these letters, but every attempt to shorten them has had the opposite effect.

Why do we pour so much time and energy into quarterly letters?

IMA’s goal is to produce attractive risk-adjusted returns while keeping the volatility of our clients’ blood pressure to a minimum.

To achieve such a goal, portfolio managers have only three general tools in their quivers: (1) have access to better information, (2) do better research, and (3) be more rational than others. (I am paraphrasing Russell Fuller’s 1998 paper.)

We make zero effort to succeed at #1, because in today’s world that means trading on material nonpublic, insider information and thus can lead to a top bunk in prison and a roommate who may not share your sexual orientation preferences.

Thus we focus all our energy on #2 and #3, which have a symbiotic relationship with each other.

Our Active Value Investing process is geared to capitalize on the occasional irrationality of markets. But since we invest other people’s capital (along with our own), even if we make every rational decision in the world, if our clients are not rational then the rationality of our decisions won’t matter. If we have the right clients – if our patient strategy of buying high-quality companies only when they are significantly undervalued fits with their views on investing – then we’ll be able to stick to our process and be rational when others are not.

It is easy to maintain low blood pressure in a market that is making new highs and when risk is just a four-letter word in a dusty dictionary. But at some point the risk gets un-dusted and the euphoria turns to panic, and this is when Joe Public will do what he has done  throughout stock market history: having bought high, he will now sell low.

The media focuses on active managers who are underperforming FANG (Facebook, Amazon, Netflix, Google) -loaded indices, while it should be focusing on the fact that the average mutual fund investor only captures a fraction of the returns of the mutual funds they invest in (see the Dalbar study).

Thus our in-depth quarterly letters (and occasional conversations as needed) allow us to put our clients on the same page we are on and help them to do the unthinkable: buy low and sell high and keep their blood pressure at a healthy, steady level when the market turns from rosy to blue.

Our approach is not for everyone. It requires a buy-in to our conservative value investment philosophy and a certain time commitment as well. Loosely paraphrasing Mark Twain, a person who has access to but doesn’t read our quarterly letters has no advantage over the person who doesn’t have access to them.

I’ll stop here. I don’t want to make an introduction to a long article longer then the article itself. To make reading this letter easier on your eyes, I broke it up into two parts.

What do you do when a company you own makes a large acquisition?

With the Discovery and Gilead acquisitions, we now have not just one but two reasons to walk you through our thinking on large acquisitions. Our thinking can by summarized in a very brief phrase: We are skeptics.

We assume that the acquisition will be a failure (or at least not nearly as good as the picture management paints in its handsome deck of PowerPoint slides). In our analysis, we put a lot more emphasis on risk than we put on reward. Unfortunately, corporate management usually does the opposite, and this is why most large acquisitions fail.

Here are some of the reasons large acquisitions fail.

The buyer pays too much. An old Wall Street adage comes to mind here: Price is what you pay, value is what you get. It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the last trade. When a company is acquired, though, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.

How much above, you ask?

Acquisitions have the elements of a zero sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince his board and shareholders that they are selling at high (unfairly good) price. The buyer needs to convince his constituents that they are getting a bargain. Remember, both are talking about the same asset.

This is where a magic word – which must have been invented by Wall Street banks’ research labs – comes into play: synergy. The only way this acquisitions dance can work is if the buyer convinces his constituents that, by combining two companies, they’ll be able to create additional revenues otherwise not available to them, and/or they’ll be able to eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.

If you examine why GE has been a poor investment over the last two decades, you’ll find that it’s because of poor capital allocation. They lost a lot of value in destroying acquisitions– – they bought businesses at high prices, relied on false or unfulfilled synergies, and sold (divested) at reasonable (or low) prices.

There are also a lot of dis-synergies (a term you’ll never see in an acquisition press release). The two corporate cultures may simply be incompatible. One company may have a strong founder-led culture, where decisions are made by a benevolent dictator, while in the other company, decisions are made by consensus. These two cultures will mix about as well as oil and water. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.

Hewlett Packard – the old grandfather of Silicon Valley – has been substantially gutted by large acquisitions. When Compaq was acquired in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. Then EDS (acquired in 2008) had a service culture, and Autonomy (in 2011) was a software company that actually ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.

Then you may also have a morale problem. The day before the acquisition, people at the acquired company came to work as usual – they performed their daily tasks, then maybe visited Facebook to check out their friends’ kids’ pictures. They were not particularly worried about the future. The following day, though, their job security is suddenly at risk (remember, they are the potential “cost synergy”), and instead of hanging out on Facebook, they are now on LinkedIn updating their profiles and networking with strangers. Now they worry about the sustainability of their paychecks (and finding new jobs) a lot more than how they can help this great, new, more profitable organization that may be about to let them go.

And finally, integrating businesses is difficult. Aside from the aforementioned culture problems, you have to realign global supply chains, move or combine headquarters, and merge software systems. In large companies, this task is like merging two very complex nervous systems.

So, as you see, while the acquisition press releases may tout synergies, they don’t talk about the price tags and dis-synergies (risks) that come with the deal, too.

Let’s make this point clear: Acquisitions can create value. But when a company grows through acquisitions, its management needs to have a very special skillset that is often different from that used in running a company’s day-to-day operations.

It is very important to examine the motivations of management when they make acquisitions. When management feels that their business, on its own, is threatened by future developments, their acquisitions will have a “Hail Mary” sort of desperation to them… and a corresponding price tag.

Here is one recent example that is relevant to portfolios of clients who were with us in 2016. In 2016, Teva, one of the largest manufacturers of generic drugs, acquired the generics business of Allergan (a company you own today).

Here is what we wrote in our 2016 second quarter letter:

Teva paid a pretty penny – $40.5 billion for a business that generates about $6 billion of revenue and less than 2 billion of profits – a very expensive deal. We thought the price, in excess of 20x earnings, was very high – especially considering that Teva will have to issue $7 billion of its undervalued shares that have a P/E of 10. But we are even more concerned about the $30-plus billion of borrowing Teva would have to take on to complete the transaction.

In Teva’s acquisition of Allergan’s generic business, our focus was on risk, especially since Teva issued a lot of debt to finance this deal. Since then, generic drug pricing has weakened and the market woke up to Teva’s enormous debt load. This sent the stock from the mid-$50s, where we sold the stock, to today’s resting place just under $16 (as of this writing on October 11, 2017).

What we really want to zoom in on is what management was thinking when they made this acquisition: They were worried about the future. About a quarter of Teva’s sales and half its profits came from Copaxon, a branded multiple sclerosis drug whose patents expired in 2015. Teva’s management felt it needed to make a “Hail Mary” type of acquisition, in order to dilute the impact that Copaxone would have on its bottom line. Thus, this acquisition was made from a position of weakness, not strength. The lesson (thankfully, it’s one for which we did not have to pay) is that when we own companies that are challenged by the future, we should be even more skeptical about announced acquisitions. They are more likely to be made from a position of “we need to do it at any cost,” and thus be more likely to destroy value.

Now let’s look at Discovery’s purchase of Scripps. Discovery’s management is also concerned about its future. Consumers are dropping their cable subscriptions, which come with dozens of channels that Discovery owns, and have started watching TV over the top (bypassing the cable box). In a defensive move, Discovery bought what we think is a lower-quality business – Scripps. Scripps owns HGTV, the Food Network, and a dozen other channels. Discovery paid a reasonable, though not a bargain, price, considering that Scripps is facing the same problem of cable cutting as Discovery. There is some desperation in this move – a red flag.

Discovery’s management thinking is that the combined entity will have better bargaining power with cable providers (true), and also that it will be able to cut costs (yes, synergies). Our thinking is that Scripps is not as good a business as Discovery. Half of Discovery’s revenue comes from affiliate fees – the $2 a month or so that we pay cable providers for carrying Discovery’s content – and the other half is from advertising. Affiliate fee revenue is a very stable cash flow stream, rising 3-5% a year and offsetting most of the revenue loss from cable cutting.

Advertising revenues are cyclical; they go up and down with the economy. Also, TV advertising revenues are under constant attack from the Googles and Facebooks of the world.

Only a quarter of Scripps’ revenue comes from affiliate fees. This could actually be an opportunity for Discovery in the long term, as they can negotiate higher fees for Scripps’ content. But this opportunity will be years down the road, because Discovery just renegotiated rates for most of its affiliate fees for the next five years. Scripps’ content doesn’t travel as well internationally as Discovery’s does, because food tastes are geographically-constrained and house flipping is a US phenomenon.

With the Scripps acquisition, Discovery diluted its business with a lower-quality one to make things worse, it has significantly levered its balance sheet, which even before the acquisition had plenty of debt. All the risks of dis-synergies that we discussed above are very much present here.

Discovery’s valuation is undemanding – that’s why we liked the stock – but this acquisition has made the success of the stock extremely “path-dependent.”



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