Bargain Hunt in a Money-Rich World
Opinions expressed by Contractor the contributors are theirs.
“Price is what you pay, value is what you get“– Ben Graham
Buying well is the most critical factor in the success of any investment. When we buy well, there is a big gap between the price we pay, and the fundamental value of the business for us. However, in an efficient market with many equally smart buyers vying for the same company, why is there this gap?
Related: The secret to a high-value investment
One framework that I have found useful in understanding this gap is: the market clearing price of an asset is the fundamental value of the asset for us. less the value of truly unique value creation opportunities that only we can access less psychological and technical factors that impact other buyers or the seller.
Market compensation price = Fundamental value – Unique value creation opportunities – Psychological factors – Technical factors
Now let’s take a closer look at each of these three factors that determine the spread between fundamental value and price.
1. Unique value generators
Related: The power to be unique in your industry
Sometimes, as buyers, we actually have the ability to increase a company’s core value more than other potential buyers. There are generally three ways to do this. First, we could own unique ideas in the business that we can use to build a differentiated strategic plan and identify unique value creation initiatives. Second, we could also have unique execution capabilities to drive key operational initiatives. Third, we may be able to take advantage of synergies with our other existing investments.
A few years ago we invested in a manufacturer of fire sprinkler components. It is a duopoly niche market with our company and a division of a Fortune 500 company dividing the market in half. While pursuing this investment, we were the only potential buyer to work with the former division head of a Fortune 500 company. We thus had a unique vision of the competitive dynamics and the main levers of value creation. A lever for short-term value creation was the strategic increase in the prices of our products. We were able to buy into and execute this initiative because we had a sense of the truly unique SKUs and areas where we had more competition. This allowed us to take a higher price increase on the first and a lower price on the second. Another key initiative has been to enter the large and fast growing Chinese market. Since our executive partner had previously executed the expansion strategy in China for our competitor, we were able to learn from their experience and expand into China. His experience allowed us to develop the strategy, find a local management team and find customer and supplier partners in China, turning into reality an initiative that could have sounded otherwise on paper.
2. Psychological factors
Related: Many people are overcome with fear. This is how I kiss her.
Psychological factors can be those that impact other buyers or those that impact the seller, and can lead to very attractive buying opportunities. Excessive fear, self-doubt, and the desire to conform to the herd mentality are powerful psychological factors that can lead to discrepancies between value and price. Complex situations, which are not well understood, and unloved industries or companies can also lead to such excessive fear.
For example, we invested in a company that was the undisputed leader in security consulting services for commercial buildings. The company had a big brand, a pool of talented and hard-to-find engineers, and was the leader in a high-growth, recession-resistant category. However, the company was also formed by the acquisition of six small companies that operated different information systems. In addition, the office of the CFO was very poorly managed. As a result, it became evident during the due diligence that it was extremely difficult to have great confidence in the precise profits of the business. This created fear among potential buyers and reduced the competitiveness of the auction process. As a result, we were given the opportunity to acquire the business at 10x EBITDA while comparable transactions were made at 12x-14x EBITDA. By working hard to understand the company’s profit trajectory, we were able to limit our risks and be confident that profits were within 10% of the number reported by the company. This was a prime example of an extraordinary business franchise with a localized and fixable problem, trading at a steep discount due to excessive fear among market participants.
Other psychological factors may come into play. In some situations, the salesperson is emotionally attached to their business and cares as much about who they are selling as they are about the price; for example, a founder who wishes to retire, but does not have a succession plan and is very aware of her heritage. In other situations, such as strategic divestitures, the seller is more concerned with how quickly and easily the asset can sell, and less with getting the last dollar of the price. These psychologically motivated special situations provide attractive investment opportunities by creating a wedge between clearing price and intrinsic value.
3. Technical factors
Here are some examples of technical factors that can lead to attractive prices: a forced sale when a high-leverage company encounters a short-term obstacle near a short-term debt maturity, the divestiture of a business division forced by antitrust regulators and the downgrade of stocks from an index or downgrading of debt ratings that keep investors away from those stocks due to institutional mandates.
For example, Berkshire Hathaway invested $ 5 billion in Goldman Sachs in September 2008. This was shortly after Lehman declared bankruptcy and credit markets froze. In return for the investment, Berkshire received preferred shares with a 10% cash dividend, a 10% premium payment if Goldman redeemed the shares, and a five-year option to buy an additional $ 5 billion in shares. from Goldman Sachs at a price of $ 115 per share. . As a result, Berkshire received $ 1.3 billion in cash dividends, $ 500 million in redemption premiums, and $ 5 billion in share price appreciation, which turned the $ 5 billion invested into approximately $ 12 billion.
By keeping the above three factors in mind and diligently asking ourselves which of them creates the gap between price and value, we can make consistently successful investment decisions and avoid the pitfalls of paying. too expensive for investments we love.