The Acquirer’s Multiple by Tobias Carlisle

Summary

Shorter and easier to read than Deep Value and tells the same story: (1) use the Acquirer’s Multiple to find the most undervalued stocks and (2) buy them with the largest margin of safety to give yourself the best odds to (3) benefit from mean reversion. Could be 3/4 shorter.

Key Takeaways

• For an investment idea, ideally one should be able to tell, in two minutes:
  • The idea
  • The consensus view
  • The variant perception
  • A trigger event
• What causes mean reversion? Competition.
• Graham’s cigar-butt method works very well when managing small sums of money.
  • Cigar-butt method: look for stocks with more cash and other liquid assets than debt. Then buy only those stocks at a big discount to the net value. According to Graham, it’s “foolproof” and “unfailingly dependable.”
• 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.
• Acquirer’s Multiple = Enterprise Value / Operating Earnings
  • Enterprise value tells us how much it costs to buy all of the stock and all of the debt (and other things like debt).
    • The enterprise value penalizes the company with debt by adding the debt onto the market cap. It rewards the company with cash by taking away the cash from market cap.
    • The enterprise value includes two other important costs that are like debt: preferred stock and minority interests.
  • The ‘operating earnings’ of which we speak here exclude capital gains, special accounting items and major restructuring charges. Operating earnings is the income that flows from a business’s operations.
    • Operating Earnings = Revenue – Cost of Goods Sold – Selling, General, and Administrative Costs – Depreciation and Amortization
• The key to maximizing returns is to maximize our chance at mean reversion. That means maximizing the margin of safety. We want the most undervalued stocks. And we want to make sure they survive to mean revert.
• Seek a margin of safety in (1) discount to intrinsic value, (2) balance sheet and (3) the company’s business.
• Value investors follow a simple rule like this:
  • Buy if the price is much less than the value. Otherwise, pass.
  • Sell if the price is more than the value. Hold otherwise.
• A simple method for investing systematically: research, buy, sell, rebalance.
• For industrial companies look at Acquirer’s Multiple, for financial companies look at book value for undervaluation.

What I got out of it

The Acquirer’s Multiple by Tobias Carlisle gives a decent overview of Graham-style value investing and early-stage Buffett-style activist (value) investing. It updates the metrics used by Graham (net nets) with a more scalable solution (acquirer’s multiple).

It’s a much easier and quicker read than Carlisle’s Deep Value and cuts out a lot of the fluff of that book. Still, it’s very limited in its scope and could have been written in 1/4 the number of pages. Other investment books such as Beating The Street, Common Stocks and Uncommon Profits, The Intelligent Investor or Margin of Safety provide more value.

Summary Notes

How The Billionaire Contrarians Zig

Billionaire global macro investor Michael Steinhardt’s approach to an investment idea: Ideally one should be able to tell, in two minutes, four things:

1. The idea
2. The consensus view
3. The variant perception
4. A trigger event

Thinking like an owner implies:

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

Why buy a company with a failing business, even if it is undervalued?

• 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.

What causes mean reversion? The microeconomic answer is simple: competition.
Fast growth and high profits attract competitors – entrepreneurs, and businesses in related industries. Competitors eat away at the growth and profit. Losses cause competitors to fold or simply leave the industry, and the lack of competition creates a time of high growth and profit for the surviving businesses.

The Acquirer’s Multiple buys stocks with mixed profits: some are highly profitable, others break even, and others lose money. It relies on price mean reverting to the value and the businesses improving.

Young Buffett’s Hedge Fund

“My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made the decade by far the best of my life for both relative and absolute performance.” – Warren Buffett

Buffett split his investments into 3 groups:

1. Generals – simply undervalued stocks.
2. Workouts – stocks on a timetable that did not wait on market action. Some other force put these stocks on a rocket sled.
3. Control situations – if a general stayed undervalued too long, Buffett would keep buying until he owned enough to control the company.

Our willingness and financial ability to assume a controlling position give us a two-way stretch on many purchases on our group of generals. If the market changes its opinion for the better, the security will advance in price. If it doesn’t, we will continue to acquire stock until we can look to the business itself rather than the market for the vindication of our judgment.

Buffett’s Wonderful Companies At Fair Prices

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.

The owner of the good business wants the business to reinvest and grow because that growth is profitable. The owner of the bad business wants all the earnings paid out because the growth destroys value.

The Acquirer’s Multiple

Acquirer’s Multiple = Enterprise Value / Operating Earnings

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.

Enterprise value tells us how much it costs to buy all of the stock and all of the debt (and other things like debt). Sometimes we find good news; the company has lots of cash and no debt. That makes it cheaper than it appears.

The enterprise value penalizes the company with debt by adding the debt onto the market cap. It rewards the company with cash by taking away the cash from market cap.

The enterprise value includes two other important costs that are like debt: preferred stock and minority interests. 

A low or negative enterprise value is a good thing to find. It means the company has little debt and lots of cash relative to the market cap.

The enterprise value is the true price of a company.

The ‘operating earnings’ of which we speak here exclude capital gains, special accounting items and major restructuring charges. Operating earnings is the income that flows from a business’s operations. It leaves out interest and taxes. It also leaves out unusual, one-off things like gains from selling an asset or settling a lawsuit. The one-off items are left out because they won’t occur again in the future. They don’t show the usual operations of the business.

Operating Earnings = Revenue – Cost of Goods Sold – Selling, General, and Administrative Costs – Depreciation and Amortization

Operating earnings are very similar to earnings before interest and taxes or EBIT. Many times, the numbers will be identical. But operating earnings differ from EBIT because the operating earnings figure is worked out from the top of the income statement down, and EBIT is worked out from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries, and sectors possible. By excluding special items – income that a company does not expect to recur in future years – ensures that these earnings are related only to operations.

The Acquirer’s Multiple is best for comparing two or more companies. We work it out for every company listed on the stock market. Then we look for the most deeply undervalued – those with the lowest Acquirer’s Multiple.

The Secret To Beating The Market

What caused the Acquirer’s Multiple to beat the Magic Formula? Mean reversion. Choosing stocks on historical profitability reduces returns.

Cigar-butt method: look for stocks with more cash and other liquid assets than debt. Then buy only those stocks at a big discount to the net value. According to Graham, it’s “foolproof” and “unfailingly dependable.”

Cigar butts beat the market. Loss-making cigar butts beat profitable ones. Cigar butts that didn’t pay a dividend beat those that did. Why? Mean reversion.

The key to maximizing returns is to maximize our chance at mean reversion. That means maximizing the margin of safety. We want the most undervalued stocks. And we want to make sure they survive to mean revert.

Three rules covering the margin of safety:

1. Value. 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.
2. Balance Sheet. Find a margin of safety in a company’s balance sheet. We need to make sure the stocks have more cash than debt or that the debt is small relative to the business.
3. Business. 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.

The Art Of Deep-Value Investing

Highly profitable stocks only beat the market if Buffett’s moat protects the profits. Without the moat, highly profitable stocks will get beaten up by the competition.

“Most decisions should probably be made with somewhere around 70 percent of the information you wish you had. If you wait for 90 percent, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.” – Jeff Bezos

Golden Rule of Predictive Modeling: for lots of problems, simple rules make better forecasts than experts.

Value investors follow a simple rule like this:

• Buy if the price is much less than the value. Otherwise pass.
• Sell if the price is more than the value. Hold otherwise.

A simple method for investing systematically:

1. Research. Ignore any stocks you do not want to own for any reason. Hold at least twenty stocks for diversification.
2. Buy. It’s best to buy all your stocks at once. But it’s fine to scale in – make regular portfolio purchases over twelve months. One way to do it is to buy two or three stocks each month.
3. Sell. For taxable accounts, hold winners for one year plus one day. Then sell. That maximizes after-tax returns. 
   1. If a stock is up and still in the [Acquirer’s Multiple] screener after one year and one day, hold until it leaves the screener. 
   2. If a stock is down and in the screener, hold. 
   3. If a stock is down and leaves the screener, sell. 
   4. You should check your stocks at least quarterly to see if you need to buy or sell.
4. Rebalance. Once you sell a stock, buy the next best stock in the screener you don’t already hold.

The Nine Eight Rules Of Deep Value

1. Zig when the crowd zags.
2. Buy undervalued companies.
   1. For most industrial companies, the Acquirer’s Multiple is the best single measure of undervaluation. The Acquirer’s Multiple is a company’s enterprise value compared to its operating earnings.
   2. For nonindustrial businesses like financials, such as banks and insurers, book value is the better single measure.
3. Seek a margin of safety.
   1. The greater the company’s discount to its value, the safer the purchase.
   2. Favour cash and other liquid securities over debt. Watch for off-balance debts like leases and underfunded pensions.
   3. The company should own a real business with strong operating earnings and matching cash flow.
4. Treat a share as an ownership interest, not a mere ticker symbol.
5. Be wary of high earnings growth and profits.
   1. The best place to find future growth and profit is in businesses enduring hard times. These businesses are also likely to trade at a wide discount to value.
6. Use simple, concrete rules to avoid making errors.
   1. Simple, concrete rules are testable. They should be back tested and battle tested. The back test makes sure the rules work over historical data sets, ideally in different countries and stock markets. The battle test makes sure the rules work in practice. No strategy has ever failed in theory. Almost all have failed in reality.
7. Concentrate, but not too much.
8. Aim to maximize after-tax gains over the long term.