One of the mistakes that I frequently make, and I am working to fix, is that I tend to only analyze assets as they are at the moment rather than taking into account what they will be–specifically, the invisible aspect of a corporation’s deal-making potential.
You may remember earlier this summer when I voiced disagreement with the professional analysts covering Anheuser-Busch that were projecting 9% annual growth at the giant brewmaker. I looked at the amount of costs already wrung out of the company, saw the anemic revenue growth, and figured there was no way earnings could grow at a rate of 9%.
What I didn’t factor into my analysis was this: The invisible, intangible deal-making ability of Anheuser-Busch executives to make an acquisition that would bolster earnings per share because the subsequent cost-cutting at the acquired company would be greater than any share dilution necessary to executive the deal.
It’s an important concept, yet one that is frequently dismissed or ignored because the endeavor is inherently speculative. But it explains why even companies like Warren Buffett’s Berkshire Hathaway, which gets gobs of attention in the Wall Street Journal and the Financial Times, is perpetually undervalued.
It is because people analyze the assets that are on the balance sheet, and chronically underestimate Buffett’s deal-making ability. He gets warrants to buy 7% of Bank of America, Berkshire Hathaway stock responds in mind. He buys Kraft, the stock trudges forward. He gets his hands on Lubrizol, more forward movement. He merges Heinz with Kraft Foods, the stock price inches up. He builds a huge stake in IBM, showering Berkshire Hathaway shareholders with hundreds of millions of dollars in dividend payments.
There is no way the current price of Berkshire should be only $136 per share. Even when the Precision Castparts deal closes, Berkshire will still be sitting on $40 billion. This gives Berkshire the untapped earnings power to increase profits by $3 billion, or 15%, annually in addition to the growth of the existing assets. The Precision Castparts deal will add 10% to earnings, and future deployment of the cash hoard will stands to add another 15% to an already excellent collection of businesses–this is an insight that I think can make a lot of long-term investors money.
I’ve already written that Johnson & Johnson is another candidate for such an acquisition. Right now, the price of the stock is $101. If you look at a historical chart, or perform some type of historical P/E analysis, you might conclude that Johnson & Johnson is fairly valued right now. I would argue it is about 10% to 15% undervalued–something worth paying attention to for a company of its caliber–because a majority of revenues come from overseas and are understated due to the strong dollar, and the unusually high cash hoard of $33 billion. Most likely, that money should be used to buy a foreign drug firm because the strength of the dollar would give the company added purchasing power outside the U.S.
What really caught my attention, though, is the recent news item that Visa is looking to purchase Visa Europe and reunite all of Visa under one corporate umbrella. That would be the size equivalent of Procter & Gamble gobbling up Gillette back in the day–it would immediately add 15% to Visa’s earnings, and provide another source of opportunity for where the company could deploy its retained earnings.
When Visa fell to $60 per share on August 24th, it was easy for me to write that it was an attractive buy. It has the best growth characteristics of any large-cap American company, a strong brand, a pristine balance sheet, a business model based on Gross Dollar Volume that automatically adjusts for inflation, and 42% net profit margins.
When the price of the stock recently climbed to $78 per share, the judgment call was a bit trickier. Now, the P/E ratio is 30. That kind of valuation makes a buy recommendation much harder because you have to figure out how much the earnings per share growth will exceed the inevitable P/E compression that will eventually follow.
This is where I drew a distinction between buying and holding. If you don’t it, it makes sense to wait for your price–in every year between 2009 and 2013, investors got a chance to buy the stock under 20x earnings. Another opportunity will come. The company was valued at 32x earnings during its IPO, and there is no need to pay an IPO price for an excellent company when a bit of patience can get you the company at a cheaper price.
The reason why holding companies you would not buy makes sense is because the acquisition of Visa Europe will add $0.40 to the company’s $2.65 per share earnings base. Suddenly, Visa is earning $3.05 per share if this rumored deal goes through, and the P/E ratio comes down to 25. And given that Visa is growing profits by 12% right now, that adds another $0.30. That could take you up to $3.35 by this time next year so that the current valuation is 23.5x next year’s earnings. Something that once appeared plainly overpriced is now inching towards reasonability given its growth characteristics.
Global mergers and acquisitions are on pace to total $4.5 trillion this year. If the subsequent earnings growth exceeds the share dilution and balance sheet debt accumulation needed to executive the transaction, then shareholders have a source of future profits that are often ignored at the time that you make the calculation.
I think investors, including myself, chronically underestimate the pace of change at their companies. That General Electric dividend that you collected in 2006 is not sourced in the same way that the dividend you will collect in 2016 is. By my calculation, the market value of GE’s acquisitions and dispositions during this time frame exceeds $100 billion and is close to $112 billion. The parent company keeps the same name–the check still shows up bearing the GE logo–but the machinery sales that are responsible for that check are not entirely the same.
What’s that old C.S. Lewis line? Every day, nothing seems to change, but when we look back, everything is different. Pull up the corporate history of a blue-chip you follow. Over the past twenty or thirty years, you will find a series of significant acquisitions. Each of Warren Buffett’s Big Four investments–Wells Fargo, IBM, American Express, and Coca-Cola–have wildly different profit sources today compared to 1950. The closest similarity is the eponymous Coca-Cola brand, which accounted for 78% of sales in 1950 and accounts for 25% of sales in 2015.
I mention all of this to say that you are only one significant earnings beat or new acquisition away from having to reassess the future growth projections of an investment. Oftentimes, exceptional performance and perceived overvaluation walk hand in hand–it makes perfect sense that a stock will appear pricey during a time in which the business is delivering its best business performance.
This is why I do not subscribe to the theory of “Why bother owning something that you wouldn’t want to buy now?” The answer is that I don’t buy something that is trading at an unusually high P/E because patience will eventually be rewarded and I don’t want to project the recency bias into long-term future returns. But I also don’t think it is worth selling a good stock because good business developments seem to regularly greet businesses performing well, and it is enjoyable to stick around and capture the high earnings growth while it lasts. Regarding a buy and hold as a distinctly different decision is a good way to address this seeming paradox.