In my earlier blog post about the Constant Dividend Growth Model of valuation, I stated that it was not a practical way to value your investments in the stock market because, as a small investor, you have no control over how the cash flow from the company is used. I then stated that there is one renowned investor who does use the CDGM as a model and is able to pull it off. Who is it? Of course, it is the Sage of Omaha, Warren Buffet.
Mr. Buffet is able to make it work because he buys entire companies at once. He usually pays all cash – no junk bond, financially-engineered deals for Mr. Buffet. (When I say “he”, I mean his company, Berkshire Hathaway). As a result, he appoints the company’s management, and he controls how the company’s cash flow is utilized. Typically, the newly-acquired company becomes a subsidiary of Berkshire Hathaway. This is what happened with a recent acquisition, Burlington Northern Santa Fe Railroad.
Ever notice that when news breaks that a company is being acquired, the stock price jumps up? That is because the acquisition price announced is usually higher than the stock’s closing price the preceding day. (Acquisition deals are usually made public when the stock market is closed – often over the weekend or Monday morning prior to market opening, or otherwise usually any morning prior to opening.)
The amount by which the stock moves up after announcement of a deal, or the difference between the closing price prior to acquisition and the acquisition price, is the Control Premium. It is often 15% or more of the prior closing price. It answers the question, “How much more (per share) would you pay for this company if you could control everything about it?”. The flip side of the Control Premium is the Minority Discount – the amount less per share that a minority shareholder (i.e., you) pays than would a controlling owner.
There is an entire genre of investing called Event Driven investing that seeks to profit on acquisition announcements. Another pejorative name of this type of investor is a Corporate Raider. Think of it as fishing. Throw your hook in the water and wait for a fish to bite. Throw many hooks in the water and wait for many fish to bite. When one fish bites, reel it in, cook it up, and wait until the next bite. The “fish” that you are eating in this case is the Control Premium. Famous investors have made fortunes doing this. Some of those famous investors have tried to rig the game by digging for information about companies who are in the process of being acquired but haven’t yet announced it. This is called Insider Trading. One of the most famous of the convicted insider traders/corporate raiders was Ivan Boesky, back in the 1980’s. Maybe I am showing my age by resurrecting his name. Boesky went to jail. Not every “fisher” goes to jail. Fishing (not “phishing”) for acquisition target, if done without the assistance of insider information, is a perfectly legal, legitimate investing strategy.
Stocks are very highly valued right now, according to historical metrics such as P/E Ratio. Many of the Indexes are hitting all time highs. When the market is at a high, there are fewer arguments that individual stocks are undervalued. When there are few undervalued stocks, there are fewer acquisition deals. Long way to say: This is not a good market for those looking to fish and look to cash in control premiums. Notice that Buffet himself has not made a lot of acquisitions lately. Everything he would want to buy is too expensive. No “margin of safety”. That’s why acquirers of entire companies have to be long term investors. They have to be patient and not bet the house on a new acquisition when prices are high. They have to hold through ups and downs.