Evidence Based Investing Is Value Investing
At Nintai we have a client - privately held Doctor Evidence (DRE) - that supplies healthcare organizations with the detailed reports on the latest evidence from clinical care and drug research. The company recognized the value of patients seeking the most efficacious treatments and obtaining the data to support their decisions. In addition, healthcare organizations from pharmaceutical companies to managed care organizations purchase DRE's data to assist in creating the most effective treatment protocols, drug development, and formularies. The company is doing an outstanding job in the new field of Evidence Based Medicine that will play an increasing role with ACA (or Obamacare) implementation. The use of evidence in defining treatments for better patient outcomes has been a long time coming in healthcare.
I bring all of this up because we believe the use of evidence is sadly neglected in our investment community. Over the course of our career, we have seen several major themes where the evidence diverges from the practice. These include active management versus indexing, high turnover versus low turnover, and high fees versus low fees. The preponderance of evidence in each of these point very clearly in one direction. And yet our industry has aggressively marketed a system that by and large rejects this data/evidence to the ultimate cost of individual investors.
As value investors we have the ability to use evidence to drive our investment decisions. One way of using such historical evidence is researching whether management is a good steward of capital and shareholder value. At Nintai, we've found that one aspect of stewardship in particular is so divergent from the evidence - and so important to investor returns - we use it as simple divider between adequate and great management. Sometimes it is the main decision between investing and not investing. This area is the field of mergers and acquisitions.
Mergers and Acquisitions
One of the tools we use to analyze management is not whether management’s M&As is successful, but whether they do them at all. Why? Because all the evidence suggests that in general, M&A activity adds nothing to shareholder value and in some cases subtracts value.
Depending on whose research you choose to rely on, mergers have a failure rate of anywhere between 50 and 85 percent. A KPMG study of 700 mergers found that while 82% of respondent felt their strategic deal was a success, the evidence showed the exact opposite. Only 17% created real value while the remaining 82% "were unsuccessful in creating any business benefit as regards shareholder value". (KPMG, “Unlocking Shareholder Value”, 1999) A study by A.T. Kearney concluded that total returns on M&A were negative. (A.T. Kearney, “M&A Deal Evaluation”, 2013) And a McKinsey study of mergers found that less than a quarter generated excess returns on investment (McKinsey, “Merger Valuation: Time to Jettison EPS”, 2005).
The primary reason for these failures is twofold. The first is overpaying for the asset. Like many of us do on a daily basis, it is critical to agree to a price that assures adequate returns in the future. (for additional details see McKinsey, “Where Mergers Go Wrong”, 2004). This is rarely achieved. The second reason is that while it's very easy to agree to the deal, the devil lies in the details. It's simply very difficult to work through issues such as culture, management strategy, mistakes in negotiation, or an adequate integration plan (for additional details see PwC “Post Merger Integration Study 2009”, or PwC “Avoiding Post-Merger Blues”, 2008).
So why do shareholders obtain such poor returns on these deals? As I mentioned previously, if the acquiring company overpays, this benefits the targets shareholders entirely. For the acquiring shareholders there is the inevitable dilution, possible dividend cuts, and finally writing down of good will. There is no amount of cost cutting, savings from (in that awful consulting word) synergies, or dramatic growth that can provide an adequate return for price paid.
The Nasty Legacy of Goodwill
Assuming the company leadership believes - against all evidence - they will do a deal that produces dramatic value to shareholders, nearly all of them overpay. This isn't necessarily bad. Sometimes it's worth buying a company that has enormous competitive advantages, products that enhance current product, or have the ability to grow far in excess of historical performance. But most of these deals - pushed by investment bankers, management consultants, and those fairy creatures on the shoulders of the CEO - create enormous goodwill.
Goodwill is (put far too simply) the amount the company overpaid for its acquisition. The excess of price versus value is added to the balance sheet as goodwill or intangibles. Annually, the fair value of these assets are measured and followed (inevitably it seems) by the mark down acknowledging the Prince was actually a rather slothful and enormous Toad. Most of the time management will try to convince shareholders this is a victimless crime. They will thunder nothing has changed in the company's cash position. While technically true, the damage was actually done when the deal was agreed to by management. Companies have three ways to finance M&A - cash, stock, or debt. Anytime a vast amount of goodwill is written down, we as shareholders take a loss. Similar to stock options, someone in the end has to pay the piper. There is no free lunch when it comes to poor decision-making.
Don't think goodwill impairment matters? According to the Duff and Phelps (Duff and Phelps: 2013 Goodwill Impairment Study, 2014), roughly 37% of all publicly traded companies recognized goodwill or asset impairments. Of these, 59% were due to specific issues mostly related to M&A activity, 24% due to industry market downturn and 17% due to general market downturn. In essence, the evidence shows that roughly one out of three public companies record a write down on goodwill each year. That’s an awful lot of additional evidence M&A isn’t the most valuable transaction for shareholders.
A great way to generally track how much management has overpaid is to watch changes on balance sheet in the intangibles to total asset ratio. An example of a company clearly growing through acquisition is NASDAQ OMX Group (NDAQ, Financial). In 2004, roughly 25% of all assets were made up of goodwill. By 2012, that number had increased to roughly 77% before coming down to 63% in 2013. During this same time revenue grew from $7.52/share to $18.75/share (or 10.7% annually). Share count increased from roughly 91M to 170M. While it's impossible to tell quickly whether these acquisitions brought real and sustained value to shareholders, it's relatively clear management significantly overpaid in their M&A. As an investor, I would seriously question whether I would put my investors' hard won treasure at the disposal of this management team.
Why It Matters
Mergers and acquisitions can tell you a lot about management. Most importantly, it tells a lot about have they feel about the overwhelming evidence about these transactions. Several key assumptions can be made if you have a team whose core strategy is growth through acquisition. These include:
Management That Overpay Are Not Great Stewards
Much as we won’t invest in a company where we cannot project an adequate return on investment in the long term, we want our portfolio company managers thinking similarly. It's hard enough to control our own emotions and act on evidence without worrying whether our investments’ management teams are keeping their own animal spirits in check. All business - not just investing - is about value. Those that don't understand that are simply not worthy of our investment dollars.
Over Payment Is Less About Business and More About Ego
I'd like to think that every major strategic decision by management is couched in the terms of shareholder value. There will always be exceptions - eating healthcare costs for employees, corporate giving, etc. When an executive makes a bad decision in M&A, it's usually because they aren't worried about the business. It's about personal leadership, fiefdoms, and showing the world what they can do. All CEOs need some of that spirit to some extent - just not at the negotiating table with a checkbook.
Poor Allocators Ignore Good Evidence
A bad M&A deal shows a CEO ignoring two key pieces of evidence. First, most deals provide no value to the acquiring company's shareholders. Because of this, management should be especially leery of such activity. Second, the CEO has ignored evidence that such a deal might not work out in the end. In these cases management has done a grave disservice by not thinking through the downside. Like all good investors, management's first job should be protecting against loss. After that is settled then by all means talk M&A. But understand the odds and act accordingly.
Conclusions
Evidence is a very powerful tool to divining the advisability of an investment. Much of this evidence can be found right in a company's financials. Such issues as management's capital allocation skills or stewardship of shareholder value can be weighed and measured. Equally important, we must be cognizant that as investors we can fall into the very same trap management has - overpaying because of an abundance of enthusiasm and animal spirits. Evidence is the guard rails which keep us steady on our road of value investing. We can ignore at our own risk or use it to greatly increase our odds. Other industries such as healthcare are demanding that evidence be the basis for medical and policy decisions. It's time we do the same. It can be a vital tool in our arsenal for producing adequate returns for our investors.
As always, we look forward to your thoughts and comments. We hope everyone had a wonderful holiday season and wish you a happy and healthy New Year.
