Posting the CROIC article on Wednesday might have been one of the best things to have ever happened to this blog. All you critters keep coming out of your corners, and hitting the contact me page. And I love you for it.
Another critter came out of the woodwork to say,
“why won’t you STFU about buyouts?”
Alegbra, My Dear
Let’s make this very simple. I look for firms with a long-term competitive advantage (CROIC provides me a mechanism through which I spot check for an advantage). I also want firms that provide a good free cash flow yield. Free cash flow yield is free cash flow divided by the price of the stock. A company that provides FCF of $1 per share and trades for $8 per share has a FCF yield of 12.5%.
That kind of FCF yield is unbelievably sexy, and fairly uncommon, but you get the point. If I purchased the whole business for the per-share price, I would receive a 12.5% return on my investment in perpetuity forever. Seeing as I want to own firms that will be around for 50 years or more, I would absolutely kill the market with this investment over the long haul.
Using this DCF calculator, I enter $1 per share in earnings, assume a 4% growth rate for 5 years, and then 2% thereafter. Finally, I enter 15.77% in the “return available on appropriate market index,” which is the effective discount rate on this particular investment, to arrive at the $8 per share price. (Please go to that DCF tool and enter the above information as I did. It really helps in following along.)
How Buyouts Work
Buyouts require that a majority of shareholders approve the transaction. The firm making the offer presents a basic mathematical model with their appropriate discount rate for the future earnings of a company.
This discount rate is NEVER as high as 15.77%. Shareholders would feel as though they are getting screwed, and rightfully so.
So let’s say the buying firm comes up with an 8% discount rate. The buyer uses 4% as a risk-free rate plus 4% risk premium, which is pretty high. Now, go back to the DCF calculation and enter 8% as a discount rate where you had previously entered 15.77%.
According to the DCF model, the company is worth $18.55 at an 8% discount rate. Thus, if another company, private equity firm, or individual activist investor were to purchase the company in full at an 8% discount rate, it would have to offer $18.55 per share for the company. I would have turned $8 into $18.55 for a total return of 131% on my $8 per share purchase price.
Notice that this is only the value of the future income stream. What if the company had $3 in net cash per share? Well, add that on top, because it needs no discounting. The new buyer can suck that $3 out immediately, and/or use it to finance the purchase. Slap that $3 on top and you get a $21.55 per share price for a total return of 169%.
But what if the buyout never comes to fruition?
Well, there are really two possible outcomes:
- I hold onto shares of stock which essentially provide me with a 12.5% return year after year. Certainly, it is possible that the stock market will never price in the earnings of the firm and I don’t realize this return. But all markets do find equilibrium…eventually. Hence why the value perspective requires you to look for firms that will be around in 20 years just as they are today. This is important both for the preservation of capital and for the necessary requirement that we find firms worthy of discounting.
- Mr. Market eventually catches up to a more reasonable valuation of the firm. Let’s say Mr. Market says the implied 15.77% discount rate is too high and instead discounts future earnings by 12%. Entering 12% into the DCF calculation, you arrive at a value per share of $11.07, a 38% return. Or, heck, what if the market prices it at a 10% discount? The per-share price goes to $13.87, for a return of 74%. Assuming that the market takes 2 years to catch up with my valuation model, I will be happy with both 38% and 74% returns on my investment.
WARNING: You shouldn’t own a crappy company destined to disappear in 5 years, even if it offers a 20% free cash flow yield. You’ll merely get your money back, in the best possible case. More likely, the C-level executives will go around talking up their “turnaround story” while they waste shareholder’s cash trying to revive what is certain to be a dead business. C-level executives have no incentive to close the company, liquidate, and return cash to shareholders as that would end their multi-million dollar annual salaries.
The Individual Investor’s Advantage – Or Why I’m not in Jail
The individual investor like myself is not crippled by the damning disease of having too much money to manage. Warren Buffett, Carl Icahn, and other big players are almost required to buy out whole companies when they see an investment opportunity. If you have $100 billion to manage, it’s pretty hard to make $100 million of stock worth your time. It would be far more favorable to buy out the whole of a $20 billion company.
Likewise, as the amount of money you have to manage increases, the expected return decreases. Warren Buffett and Carl Icahn are more than happy to buy out firms with an 8% discount rate, since the alternative is a 30-year Treasury bond that yields less than 4%.
Frankly, I’m not at all happy to generate a measly 8% per year on my tiny amount of invested capital. Tiny is basically any amount less than hundreds of millions. The ability of an investor to outperform is inversely related to the amount of money he or she has to invest.
Because I can make partial ownership of a company (partial ownership being a few fractions of a single percentage of the company’s value) I have opportunities where wealthier asset managers do not. I find it highly unlikely that anyone reading this blog is managing billions of dollars. Given that you aren’t in charge of multi-billion dollar investment pools, you have an edge.
I do not have to play by the same diversification rules, either. If I were to make my portfolio a mutual fund, I would be in jail. Mutual funds have very serious diversification rules, which require a minimum of 20 holdings (a fund can hold no more than 5% of its assets in a single security.) The idea of holding 20 securities is beyond me – it makes little sense to dilute your portfolio with “okay” companies if you have 6-8 great companies.
And of course, there have been times where I’ve put 50%+ of my portfolio in a single company. Nothing risked, nothing gained – the last time I put more than 50% of my portfolio in one company my position doubled in value in less than 6 months. I really don’t think that to be nearly as risky as it sounds. If you are going to do the analysis on a particular firm, there’s no reason to doubt yourself. Have some confidence in the calculator – it’ll make you money!
Buyouts are my favorite way to exploit my small investors’ edge. There’s nothing better than buying a company with an expected annual return of 12-15% and having it purchased from you with an implied expected return of 6-8%. You can compound your portfolio much faster when you have what I call “takeover turnover.”