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Acquirer’s Multiple: Finding Deep Value Investments

Tobias Carlisle’s beginner-friendly introduction to deep value investing by investing into undervalued companies with a large margin of safety.

The Book “The Acquirer’s Multiple” by Tobias Carlisle is a beginner-friendly version of his classic “Deep Value”.

In it Carlisle describes his approach to deep value investing using the acquirer's multiple. It is a valuation formula to find undervalued companies with a high margin of safety. His book describes the foundation of why the acquirer's multiple works and how it compares to other investors.

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Why Are Successful Investors Contrarians?

Tobias Carlisle begins his book with one simple thesis: Successful investors zig when the crowd zags.

This means the average investors invests in growth stocks which are close to having reached their full potential. However the interesting investments are actually failing companies with falling share prices.

In other words, successful investors are contrarian investors betting on companies other investors don’t dare to touch. These deep value stocks are expected to return above average results. The average investor however prefers to follow the crowd and therefore can only expect to achieve average results.

To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate.

Howard Marks

Contrarian investors seem to buy at the worst possible time when profits are low and the outlook of a company looks bleak. However during these times the worst-case scenarios are backed into the stock price and as a result it offers a wide margin of safety.

High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen

Seth Klarman

Another term for these contrarian investors is value investor. They buy undervalued companies which are being sold below market value. Once these cheap stocks reach a fair price they sell them at a profit.

At first buying undervalued companies might seem scary. However many seemingly bad or boring businesses can turn out to be better than anticipated. And even if the company is actually mismanaged it might attract outside investors who buy them or actively work on turning the company around. In addition those undervalued companies often have valuable assets which have been overlooked by most other investors.

Investors who want to make the market return should invest into the market. However contrarians aim to achieve higher growth and therefore need to beat the market. This is best achieved by buying undervalued companies.

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What Is Mean Reversion?

The driving force which allows value investors to invest into undervalued companies and sell them at a profit is called mean reversion. Mean reversion pushes up undervalued stocks and pushes down growing and profitable businesses. It is a simple mechanisms that works on individual companies, industries and even whole economies.

Chart showing the impact of mean reversion on stock prices
As a result of mean reversion share prices of overvalued companies fall while those of undervalued companies rise.

Mean reversion is a direct result of the human tendency to extrapolate trend. Humans tend to think that trends continue forever while in reality they don't. Trends don't tend to continue because fast growth and high profits attract competitors which pull down the growth and profit of existing companies thereby reversing the trend. Those losses then cause competitors to leave the market or go bust which leads to high growth and profits again.

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.

Jeremy Grantham

As a result undervalued stocks tend to beat expectations and lead to great results while fast-growing stocks tend to slow down and revert. Profitable businesses will see declining profits while the undervalued stocks will keep growing. Mean reversion is actually the expected outcome. But because humans tend to extrapolate trends to most it is unexpected.

On the company level mean-reversion is usually happening as a result of other activist investing by value investors. They use their shareholder rights to turn the business around.

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How Can Investors Use Mean Reversion To Their Advantage?

The key to maximizing returns is to maximize the chance at mean reversion as it results in a maximized margin of safety. The more undervalued a stock is and the better the chance at survival the higher the return and the lower the risk will be.

As companies tend towards average profitability over the long-term the undervalued stocks are the ones with the highest upside. They have plenty room to grow while highly profitable companies become less profitable.

Companies often become undervalued because their short-term future looks bleak. This is discouraging for the average investor and as a result they sell their stock. However in the long-term those companies usually have a bright future.

As a result the only way to get a good price is to buy what the crowd wants to sell and sell what the crowd wants to buy. Buying what the crowd wants to sell leads to low prices and undervaluation of companies. So focusing on the long-term can provide tremendous value to patient investors.

Value investors following a deep value strategy can take advantage of mean reversion to achieve excellent future results. Buying cheap stocks at their lowest price provides them with a maximized margin of safety. It reduces the risk of them loosing their invested capital and can help to avoid a worst case scenario of a total loss of capital.

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What Is Acquirer’s Multiple?

The acquirer’s multiple is a industrial-strength PE multiple which originates from corporate raiders and buyout firms who used it to find cheap takeover candidates. It works similar than the price-to-earnings formula.

The formula not only includes profits but also the assets and liabilities of a company. As a result it reveals hidden cash and cash flows and uncovers hidden traps and high debts. The acquirer's multiple assumes that acquirers can sell assets, pay out cash or redirect cash flows.

Stocks with a low acquirer’s multiple tend to be better than stocks with a high one. The reason for this is that low debt and a high amount of company’s cash results in a better financial position. This results in a lower acquirer’s multiple and makes these companies more attractive investments.

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How Is The Acquirer’s Multiple Calculated?

Formula to calculate the Acquirer's Multiple

The acquirer's multiple is calculated by dividing the enterprise value by operating earnings (also called operating income). The enterprise value includes the market cap of the company minus its cash plus all of its debt, preferred stock and minority interest. It reflects the true cost of buying the whole company while the operating earnings reflect the value that the investor gets back.

Operating earnings are calculated by taking the revenue of the company and subtracting cost of goods sold, selling, general and administrative costs and depreciation and amortization. Consequentially interest and taxes are not yet subtracted. This is intended as interest is tax-deductible and tax rates can differ between companies. By including interest and taxes we get back a number which comparable between multiple companies as individual factors have been taken out.

As debt is included in the enterprise value it penalizes companies with debt and rewards companies with lots of cash. The inclusion of preferred stock into the formula is important as those grant preferred payout of dividends which makes them equivalent to interest payments. Similarly minority interest have to be taken into account as they have to be paid off in case of a takeover.

Many investors only look at profits in the income statement but not the value hidden on the balance sheet. By meticulously checking it investors can find hidden undervalues gems which will provide lots of value for the investor.

It is important that the company has more cash than debt or that the debt is relatively small compared to the business. The company should also own a real business with historically strong operating earnings and matching cash flow.

When buying a company with a negative acquirer's value the investor is essentially being paid to buy the company. Those companies are rare but great opportunities as they have little debt and lots of cash relative to their market cap.

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Why Shareholders Should Use Their Rights?

Stocks are not just ticker symbols. A share is an ownership in a company that comes with rights for its shareholders. Shareholder should make good use of their rights and use them to vote at meetings or actively steer the course of a company.

They should also know what the company’s assets and liabilities are, who the other shareholders are and what the business of the company is. It is important in this instance to differentiate the term company from business here as they are often used as substitutes. A company is a legal entity which owns a business which brings in the value for the company.

Tobias Carlisle repeatedly points out how successful value investors used their voting rights to push the fate of their investments into the right direction. A prime example is Warren Buffett who categorized his early investments into three categories:

  • The generals were undervalued stocks which were waiting on the market to push up their price and which didn't need a lot of attention.
  • The workouts were stocks that needed some sort of corporate action to get back on track. This could be actions that have been taken by the management or by another dominant shareholder.
  • If the stock of an undervalued company stayed undervalued for too long it would become a control situation in which Buffett started to buy enough shares until he owned enough to control the company and turn it around himself.
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How Does Deep Value Investing Compare To Other Strategies?

Warren Buffett

Warren Buffett is famous for his investment strategy of only buying “wonderful companies at fair prices”. However Tobias Carlisle found out that “fair companies at wonderful prices”, undervalued companies with mixed profitability, tend to outperform the wonderful companies at fair prices..

Warren Buffet has managed to largely avoid the issue of mean-reversion by investing into companies with a “moat”, for example a patent or a well-known brand, which protects it from competition. However it is hard to differentiate between businesses with an actual moat and businesses which are at the peak of their business cycle. Moats also change over time as user preferences change. A good example is the newspaper business has gotten largely irrelevant with the rise of the internet.

Joel Greenblatt

Joel Greenblatt’s book “The Little Book That Beats the Market” is based on Warren Buffets idea of buying “wonderful companies at fair prices”. It describes his magic formula which aims to find attractive investment opportunities.

Tobias Carlisle compares the performance of the acquirer's multiple with the magic formula. He found that his approach outperformed both the S&P 500 and the magic formula and concluded that a high margin of safety is more important than the profitability of a company. The profitability is subject to long-term mean-reversion which dampens the return of the magic formula while the acquirer's multiple relies on companies mean-reverting to their upside.

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