Matt Franz : Zealous For Knowledge

The Acquirer’s Multiple

Most books are too long. 90% of what I read could be 50% shorter without compromising the message. Quality does not mean quantity. Hemingway’s The Old Man And The Sea is 128 pages, written in language simple enough for middle schoolers to enjoy, and won the 1954 Nobel Prize in literature.

Investing literature isn’t any different. Buffett’s allure is not just his outstanding investment returns. It’s also his ability to communicate his thoughts succinctly in a manner that anyone can understand. Consider the wisdom embedded in “Be greedy when others are fearful and fearful when others are greedy.”

The Acquire’s Multiple is a distilled, but not necessarily watered down, version of Tobias Carlisle’s earlier book Deep Value. It’s an excellent resource for someone new to value investing. Those that have already read the value investing cannon won’t learn much that’s new. But it never hurts to hear the gospel again.

The book shows investors can outperform Joel Greenblatt’s Magic Formula by dropping the quality factor. Greenblatt introduced the Magic Formula in The Little Book That Beats The Market. It’s a simple two-factor quantitative system based on the premise of buying an above average company at a below average price. Greenblatt uses return on capital employed (ROCE) to define quality and EBIT/EV to define value. Carlisle calls Greenblatt’s earnings yield the acquirer’s multiple. He defines it as the ratio of enterprise value to operating income.

The key idea in The Acquire’s Multiple is that mean reversion is the most powerful force in all of finance.

Jeremy Grantham writes:

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.

Humans naturally find patterns and linearly extrapolate them. Sometimes we even find patterns were none exist (See Fooled By Randomness). But the forces of capitalism ensure that nothing stays on an upward trajectory forever. When a company earns high returns on its capital, new competitors will emerge. This drives returns lower until they are so unattractive that companies shut down.

Buffett has made billions buying and holding the few companies immune to this process. When a company can earn high returns for an extended period Buffett says it has a “moat” protecting it. Consider Coca-Cola. If you start a rival cola company tomorrow but it wouldn’t affect demand for Coke because people have an emotion attachment to Coke’s brand. Undercutting them on price won’t work, and the Coke vs Pepsi taste tests show that making an objectively better tasting product won’t work either.

Finding companies with sustainable moats is great in theory but difficult in practice. You can lose a lot of money buying a company earning high returns if you’re wrong and they mean revert lower. This, Carlisle argues, is why the acquire’s multiple outperforms the magic formula.

There is a lot of merit to the acquirer’s multiple, but it’s not a foolproof system. A system is only effective if you stick to it. To stick to it, you need unwavering confidence in it. Any quant strategy will ultimately underperform, perhaps for many years on end. The trouble with the acquirer’s multiple is that when you are underperforming you’re holding a bunch of low quality companies. I’d have a hard time with this.

I prefer to own high quality companies I know a lot about. That comforts me when their stock prices are down and helps me stick with my “system”. This is why I still prefer discretionary investing to a pure quantitive approach.

Nevertheless, the acquire’s multiple is a good reminder that price is the most important factor relative to returns, particularly in a 1 year time frame. Discretionary investors can use the universe of the lowest acquirer’s multiple businesses as a fertile hunting ground. Carlisle points out that a few years ago Apple was in the top 30. Occasionally, a high quality company Buffett would buy pops up an an extremely attractive price. If you have the patience to wait for and recognize these opportunities you can do quite well.

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