Antifragility, Path Dependency and Value Investing (Part 1)
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The following is excerpted from IMA’s last quarterly letter to clients.
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.