Phil Fisher on Mergers & Acquisition by Investment Master Class
Over the past few decades I've found I have learnt the most about investing from reading the books recommended or written by the Investment Masters.
I was recently reading Francois Rochon's annual letters and came across a reference to a Phil Fisher book called "Paths to Wealth Through Common Stocks". Far less well known than Mr Fisher's highly regarded "Common Stocks and Uncommon Profits" of 1958, this book was published in 1960. I managed to pick up an original copy of the book at AbeBooks.
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What I find most insightful from older books are the lessons and ideas that contribute to investment success that have remained constant over long period of times. In the terms of Nicholas Nassim Taleb, these ideas are "anti-fragile". In his book of the same name, Taleb notes ..
"If a book has been in print for forty years, I can expect it to be in print for another forty years. But, and that is the main difference, if it survives another decade, then it will be expected to be in print another fifty years. This simply, as a rule, tells you why things that have been around for a long time are not "ageing" like persons, but "ageing" in reverse. Every year that passes without extinction doubles the additional life expectancy. This is an indicator of some robustness. The robustness of an item is proportional to its life!"
Reading Phil Fisher's book, I was surprised how timeless the commentary was on Mergers & Acquisitions. Remember this book is nearly 60 years old yet its lessons are as relevant today as they were then. A lot of that has to do with the fact that human nature doesn't change and also that the basis of Mr Fisher's analysis, when you take the time to think about it, really is common sense.
In recent months I've witnessed a whole host of companies that have blown up investors capital due specifically to Mergers & Acquisitions. Investors may have saved themselves a lot of heartache over the last 50+ years if they'd taken note of the observations of Phil Fisher all those years ago.
"Why do mergers and acquisitions carry such a high degree of risk?" Mr Fisher asks.
"There are three main sources of danger to investors from mergers or acquisitions. These possible dangers should be kept in mind at all times, both by managements considering acquisitions and by stockholders in companies where such matters are under consideration"
The three dangers are, firstly that the struggle for top positions in the combined firms will so engross and disturb key personnel that former smooth working teams will degenerate into a hotbed of internal fighting and friction. I like to think of this as a clash of cultures.
Secondly, that top management will get involved with so many problems in fields with which they were not previously familiar with that they will find themselves unable to carry on with their former efficiency. The classic example of this is when management spends an inordinate amount of time dealing with their new 'problem child' at the expense of their core business.
Finally, the seller nearly always knows more about his or her business than the buyer such that the acquirer subsequently finds faults far worse than allowed for in the price of acquisition.
"Many acquisitions do not turn out as planned. The sellers know more than the buyers and may know of problems or uncertainties that are not apparent to the buyers" Ed Wachenheim
"We have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale – a time when the business is likely to be walking "just fine" Warren Buffett
Mr Fisher notes that acquisitions that help integrate a company backward, such as acquiring a captive source of some of its raw materials, component parts or other supplies, seldom involve a sizeable degree of investment risk. This is because there is less likely to be a power struggle in management, the acquirer likely knows the business well and is unlikely to out-traded with regards to purchase price. These acquisitions are unlikely, however, to be tremendously beneficial to the shareholder.
When it comes to acquisitions that integrate forwards, such as acquiring a captive customer outlet, similar expectations ordinarily apply. The exception to this is if management makes the mistake of acquiring one company that competes with a number of its existing customers and fails to allow for a loss of sales to these former customers as they are now deemed competitors. Mr Fishers notes "such a move can be very costly".
Ordinarily small bolt-on acquisitions tend to be of limited risk yet too small to make much of a difference to the stock holder. Mr Fisher notes however "occasionally this is not true". Such a scenario is where the tiny acquired company brings a new product line which can be scaled by the acquiring company or when one or two outstanding individuals from the small company can make a major contribution to management. "Acquisition of this sort can not only be the least hazardous but also the most profitable in the entire field of mergers".
Mr Fisher notes that mergers or acquisitions that have the greatest prospect of being a long term success involve companies in similar lines of business that have been aware of each others activities for years and have a thorough understanding of each others problems.
Conversely, the greatest chances of a costly failure occurs when a merger or acquisition happens quickly between two companies in quite dissimilar lines that were previously only vaguely aware of each other. This is a red flag for shareholders. I can think of plenty of cases over the years where companies have acquired businesses outside their core competencies with disastrous results.
"If a company must acquire something, I'd prefer it to be a related business, but acquisitions in general make me nervous. There's a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them." Peter Lynch
“The fact of the matter is that, for most declining businesses, management tends to redeploy cash flow into things outside of their core competencies in a desperate attempt to save their jobs” Jim Chano
Mr Fisher notes the most successful record has been made by companies that only make acquisitions very occasionally, in similar businesses, and when all measurable factors seems overwhelmingly propitious. Such deals are usually a good deal for shareholders because the acquiring company "only does what comes naturally" and is not straining to be making deals" all the time.
“With acquisitions, patience is a virtue .. as is occasional boldness” William Thorndike
“Two thirds of acquisitions don’t work. Ours work because we don’t try to do acquisitions — we wait for no-brainers.” Charlie Munger
Conversely there maybe quite a high degree of investment risk in a company that as a matter of basic management policy is constantly trying to grow by acquisition. These companies are what are commonly referred to today as 'roll-ups' - think Vaelant [see more on the history and risks associated with 'roll-ups' here]. Mr Fisher notes the risk is even greater when the CEO spends a sizeable amount of time on mergers and acquisitions or the company assigns one of its top officer group to making such matters one of its principal duties. In either event powerful figures within a company usually acquire a sort of psychological vested interest in completing enough mergers and acquisitions to justify the time they are spending. I've witnessed a lot of permanent loss of capital arising when the psychological forces of greed, groupthink, commitment and confirmation bias come to the fore in mergers and acquisitions.
"In the field of mergers and acquisitions, multimillion even billion-dollar deals get under way and the momentum builds, the rivalries among the players come to the fore, the game - a game it becomes - goes ahead, no holds barred. Someone is determined to win! They can taste it! All the cash lying on the table, all the supposedly solid rationale behind the deal, all the people involved-nothing matters except winning! "I want my way," says the biggest ego in the room! There are dreams of being in the press conference spotlight and big headlines in the Wall Street Journal. It's all too glamorous and we convince ourselves that the numbers do add up - even when they are about as sound as astrological predictions. The "animal spirits" that John Maynard Keynes wrote of are more powerful than most business people would like to admit. Look at the recent dreadful fits - Daimler and Chrysler Time, Warner and AOL, Kmart and Sears, Quaker Oats and Snapple. Should these really have ever happened?" Donald Keough
The least desirable acquisitions are those where a not particularly attractive business is acquired at a very low price in relation to existing assets and past earnings. Mr Fisher notes that companies that would otherwise have been a magnificent opportunity for shareholders have a number of times been made quite unattractive by a management with one good line of great intrinsic strength and potential, acquiring several weak or run-of-the-mill types of business. Usually this is done with the explanation to shareholders that by diversifying the company's activities, the shareholders position is being strengthened. When this happens, the previously steady upward trend of the price of the company's shares sometimes comes to an abrupt and perhaps permanent halt.
"A serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette). Loss of focus is what worries Charlie and me when we contemtplate investing in busineesses that in general look outstanding" Warren Buffett
"Instead of buying back shares or raising dividends, profitable companies often prefer to blow the money on foolish acquisitions. The dedicated di-worsifier seeks out merchandise that is (1) overpriced, and (2) completely beyond his or her realm of understanding. This ensures that losses will be maximised" Peter Lynch
Mr Fisher concludes that mergers or acquisitions other than between companies in vastly different size in quite different lines of business should be studied with the greatest care and greatest suspicion.
"Mergers then may be summed up as matters the investment significance of which can vary enormously, one from another, depending on the nature of each. The really big ones, I believe, usually contain far more pitfalls to the shareholder than they do promise"
The more things change the more they stay the same.