Why Serial Acquirers should trade at a discount, not a premium

Was it all money supply?

Hello Coffeedrinkers!

In the last decade serial acquirers, companies that mainly grow through acquiring others  - have had exceptional returns. Companies like Constellations Software created more than 40% annualized returns during the last 10 years and even big companies like Danaher have had an impressive run. As a result optimism around those companies is high. Whereas the intelligent investors warns of companies that have too many acquisitions, it now seems to be a desirable characteristic.

Here is a great article about serial acquirers and a graph that I have borrowed from the article showing the yearly returns of several serial acquirers.

Studying Serial Acquirers

With their stock price, not only did the enthusiasm increase, but so did valuation. Of course many of the companies have great management and incredible capital allocation, however they now often trade at steep premiums compared to their peers.

Berkshire a holding company that has acquired lots of businesses over the year trades at 1.18x P/B. They have a proven track record and arguably the best investor of all time at their helm. Looking at industry numbers, Berkshire does not trade at a premium despite their long history of success and neither should the rest of the serial acquirers.

While I criticize Constellation Software a lot, those criticism apply to other serial acquirers as well (exceptions exist tho)

Niche Acquisition and inorganic growth.

Most of the companies specialize in niches. They then acquire companies in that niche, dominating the industry. That ensures that the companies have expertise in their field, but it also often limits the organic growth. As a result the companies' valuation are only justified by a string of acquisitions and not by their organic free cash flow growth. The 10th man who has a great analysis on Constellation Software shows us this in a graph:

As we can see Constellation Software organic growth is abysmal (it was around 5% in 2021), especially if you compare it to the growth spend on enterprise software worldwide. While Mark Leonard, the CEO of Constellation Software, buys companies at impressively low valuations -  it seems that those are justified given the lack of growth embedded into those acquired companies. Smaller growth is expected in those specialized niches- but it seems that they don't have the pricing power to offset the lack of scale growth. As a result, the companies need to buy more and more or bigger companies, risking foregoing due diligence or a failed merger.

Size problems

If the companies capital allocator is excellent, soon the company has a problem: It won't grow a lot if it doesn't either increase the size of acquisitions or their quantity. This increases the risk for companies significantly. In addition to the usual operation and duration risk of products and services now comes the risk of a failed acquisition.

The 10thman has another great graph here that tells use more about Constellation Software's acquisitions.

We see that while their deal size has stayed around the same, the number of company significantly grew. Obviously the team of Constellation grew as well, but even if -  processing all those deals creates a significant risk. Furthermore there is a limit to what you can buy -  especially at good prices. Good deals are not always available and there is a limit to your growth in your niche. Moving on from that niche can be very hard, due to the lack of expertise.

Complexity and the Share Problem

Serial Acquirers are often extremely complex. They have subsidiaries of acquired companies, holding companies inside their companies and more. Most of the time it also comes with worse business quality overall. That in my opinion should warrant a discount, but the market does not seem to agree.

The biggest problem with serial acquirers is their capital allocation regarding their own equity. In the 1970s we had conglomerates buying up every business with their overpriced shares that they could get their hands on. In their frenzy that lead to bankruptcies and shareholder value destruction. One of the few that managed the environment perfectly was Henry Singleton. The CEO of Teledyne used their overvalued stock to buy undervalued companies during the frenzy. Once it stopped and the shares went from trading at a premium to a discount he bought back 90% of the company in 12 years, achieving great returns for shareholders.

Buffett used his overvalued shares in 1998 to buy General Re. This tripled the insurance float, while diluting shareholders by just 17%. Today quite a few allocate capital to buy back shares, but they often do not use their share premium to acquire companies. This is also the case for Constellation Software which is seen as the best of the serial acquirers. Even at the currently very high valuation they refuse to dilute their shareholders to buy a cheap company. Mark Leonard the CEO has bought companies at exceptional prices, so a dilution could very much be a positive for the shareholders over the long term.

Share capital allocation is one of the most difficult decisions a company has to grapple with. Finding companies that create value when the share price is high and low is difficult.

Historic value destruction in acquisitions

Bruce Greenwald, the teacher who taught Li Lu at Columbia Business school, is not a fan of acquisitions. Thanks @DevinHaran for the great share. 

“An acquisition is a priori an inferior choice for a firm w. capital available to invest or return to shareholders. A standard acquisition involves a concentrated investment at above market prices w. high transaction costs. It makes little to no business sense.” 

“An acquisition is by definition a concentrated investment in a single enterprise- Acquisitions are typically made via highly competitive auction processes involving a multitude of sophisticated participants…including well-capitalized bidders, well-informed sellers, and experienced bankers who are highly incentivized to maximize the premium paid.

“Imagine being approached by a mutual fund salesman who is selling a fund that has limited diversification, sells for more than the net asset value of the shares it owns, and carries with it an exceptionally high commission.” 

“In order for a merger or acquisition to be justified, the buyer has to contribute something to the combined enterprise.”

“Even in these favorable circumstances, the history of strategic acquisitions has been painful for shareholders of the acquirer. Returns to shareholders of the acquiring companies are dismal; the companies typically lose ~20% of their value over the next 5 yrs.” The firm making the acquisition has the option of making a different kind of investment, either directly or by distributing the money to its owners.”

Conclusion

I have no doubt that many of the acquisitions add value to the companies. Many of the serial acquirers have proven themselves to have excellent capital allocation. As they grow both in size and in acquisition quantity they should still trade at a discount, not a premium given the added risk through complexity and potentially failed mergers. 

The last decade saw historically low interest rates, big growth in money supply and many industries expanding significantly. How much value serial acquirerers create once that circle of business and money supply expansion is over remains to be seen.