Thursday, September 2, 2010

Buffett on the Competitive Nature of Corporate Acquisitions: Berkshire Shareholder Letter Highlights

In the 1980 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett explains the potential advantages of buying a partial interest in an enterprise through common stock vs outright ownership of an enterprise. To place 30 year old commentary on corporate acquisitions into a more recent context, I think the following provides some insight into why Buffett was less than enthusiastic with the purchase by Kraft of Cadbury.

From the 1980 letter:

The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage. This is true whether we determine the usage, or whether managers we did not hire - but did elect to join - determine that usage. (It's the act that counts, not the actors.) And the value is in no way affected by the inclusion or non-inclusion of those retained earnings in our own reported operating earnings. If a tree grows in a forest partially owned by us, but we don't record the growth in our financial statements, we still own part of the tree.

Our view, we warn you, is non-conventional. But we would rather have earnings for which we did not get accounting credit put to good use in a 10%-owned company by a management we did not personally hire, than have earnings for which we did get credit put into projects of more dubious potential by another management - even if we are that management.

(We can't resist pausing here for a short commercial. One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.)


The competitive nature of an outright acquisition more often than not results in more than full price being paid. I've certainly seen it happen.

Too often, it's detrimental to the shareholders of the acquiring company.

In corporate acquisitions overpayment is the rule. You will be given many articulate explanations and impressive presentations by senior management why it is they are not, in fact, overpaying. Just keep in mind that when you hear the words "strategic" being used a lot to justify that premium price, expect the premium to end up in the pockets of shareholders in the acquired company and the investment banks that help facilitate the deal.

When it comes time for Berkshire Hathaway to purchase an entire business Buffett has said: "we don't do deals when we're ready to buy, but rather, when a company is ready to sell." When someone sells their business to Berkshire Hathaway they are likely trading off getting the max price with the benefits of a unique corporate culture and an owner who doesn't meddle very much.

Overpaying for a business will happen less often if you don't make getting a controlling interest in that business the priority. You just need the patience to wait for the market to serve you.

Favorable mispricings tend to occur when buying small portions of a business in a stock market environment.

Adam

Long BRKb
---
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
Site Meter