Bill Nygren’s Third Quarter 2014 Market Commentary
September 30, 2014
On the morning of September 15, TRW Automotive Holdings (TRW) announced it was going to be acquired by ZF Friedrichshafen for $105.60 per share. This was of more than a passing interest to us because at the time TRW was the largest holding in Oakmark Select. It was also the culmination of a process we applauded because TRW stock began 2012 at $33 per share, and was only up to $74 at the end of 2013. Over the years, takeovers have contributed significantly to Oakmark and Oakmark Select’s returns. In 2014 both Funds benefited when AT&T offered to buy DirecTV and when Actavis purchased Forest Laboratories. Additionally, Oakmark Fund owned Covidien, which increased from $72 to $92 after announcing its merger with Medtronic. Obviously, we welcome takeover activity in any of our holdings.
But when TRW announced news of the acquisition at 8:16 a.m. Chicago time, it took less than an hour – 9:04 to be exact – for the first law firm to announce its threat to sue TRW for accepting too low a price. Within 10 days I had counted at least 27 similar press releases from various law firms purporting to represent shareholders, threatening legal action to block the takeover. How do you square the law firms all jumping in to protect the shareholders while as a large shareholder ourselves, we were cheering the news?
Merger objection lawsuits aren’t unique to the TRW deal. In fact, each of the takeovers we were invested in had multiple law firms trying to block the deals, alleging that shareholders weren’t getting paid a high enough price. And it isn’t just those takeovers. Within minutes of almost any takeover announcement, many law firms race to file press releases. Ten years ago, less than 10% of announced acquisitions of public companies were followed by merger objection suits. Today, almost every deal produces multiple suits. The overwhelming majority of these suits result in zero benefit to the shareholders, but almost all result in payments to law firms. Effectively, these suits have now become just another unfortunate cost of doing business.
Though we believe these suits are mostly frivolous, it is definitely worth recognizing that executives of selling companies may be conflicted and in a position to capture benefits for themselves that don’t get passed through to other shareholders. Those may include higher-than-market compensation, job security for redundant positions, or a slew of perks that make their new jobs more rewarding. So I’d like to take the opportunity to discuss how we at Oakmark analyze acquisition proposals.
When we first purchased TRW in late 2011, our belief was that the stock was worth about $63. We developed that estimate of value in several ways. We looked at acquisition prices of other industrial businesses. We looked at the value of discounted cash flows based on our estimate of future earnings. And we looked at historical stock market valuations for businesses that had similar fundamental characteristics. It is a process we use for all companies we purchase, and it attempts to get us into the right ballpark for estimating value. It is definitely not an exercise in precision – when we say we estimate value at $63, it really means we believe the right range is something like $57 to $70. We would mock any of our analysts who tried to show precision to the right of the decimal point; we believe that if we are within 10% we are doing a good job. We simply don’t believe you can get more accurate based on public data. But fortunately, lack of precision was no problem with TRW because at the time we purchased it the stock traded at $32.
During the ensuing three years, TRW earned about $20 per share cumulatively and used some of that capital to buy back undervalued stock. Over that time our forecast of future earnings grew. By last month our best estimate of value had grown to $109. The acquisition price of $105.60 was a little bit below our best guess, but well within 10%. That left us with two important questions: Was the bidding process open to other interested buyers? Were the board and management incentivized to achieve the maximum price?
Let’s take the second question first. Did the management own enough stock and options that they were beneficiaries of a higher price? This is a question that is important to us not just when a company is getting acquired, but throughout our term of ownership. We believe it is too much to expect that people will act against their own economic interests, so we like to see management do well when their shareholders also do well. Fortunately, their incentives are easily quantifiable because the information is readily available in the proxy statement and 10K. As of year-end, management and directors owned or held rights to purchase over $500 million of TRW stock, valued at the acquisition price. Each dollar by which they could increase the price benefited them by just over $5 million. Clearly, by acting in their own economic interest, they were also acting in the interest of all the shareholders.
Finally, was it an open process? Again, the publicly available filings help answer this question. Any time a public company is acquired it is required to make a filing that details how potential buyers were identified and that discloses what took place during negotiations, including whether or not other offers were received. That document for TRW is not available yet, but will be by the time you read this letter. But here’s what we know so far. On the morning of July 10 Bloomberg reported that ZF was considering purchasing TRW for $11 billion to $12 billion ($95 – $103 per share). Within a couple of hours of that report TRW publicly confirmed the rumor; it had received a bid but did not disclose the price or the suitor. TRW said it was “evaluating the bid as well as other options.” Translating from legalese, this was an open invitation to anyone interested in acquiring the company to come forward. In press releases later that day, ZF was identified as the suitor. Nine weeks later the deal was announced several dollars above the high end of the rumored range. In the interim negotiations, TRW must have had some leverage to extract a few more dollars.
We know that TRW management would have profited handsomely from a higher-priced deal and that any interested parties had nine full weeks to indicate their interest. We conclude that ZF’s offer is highly likely to have been the best available. Despite the price being slightly below our estimate of value, when the facts line up like that, we would always prefer to have the deal accepted. That way, we can sell our stock at a much higher percentage of our value estimate, even if it isn’t quite 100%, and redeploy the funds into stocks that we believe are selling at much larger discounts to our estimate of value. (Note: In the highly unlikely event that the proxy statement discloses that a