Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
A microcap investor’s biggest risk is dilution, and a microcap’s worst enemy is a management team that wants to get bigger at any cost.
With over 13,000 microcap companies on US, Canadian, and UK markets, we see a lot of M&A activity. In fact, since 1992, over 60% of all public M&A has occurred at the microcap level. On MicroCapClub alone we’ve had over 40 companies acquired since mid-2011. Larger companies can use cash on hand or borrow money at very low interest rates to acquire great businesses at low(er) valuations in the microcap arena. Management teams and investors are drawn to M&A activity. We love to see companies getting bigger, faster.
According to McKinsey & Company, these are the strategic reasons for M&A:
Capital allocation is the main responsibility of a management team to deliver long term shareholder value. The dark side of M&A is that soon after a deal closes successfully, it often fails miserably. Numerous research studies have shown that between 50-90% of all mergers and acquisitions fail to meet financial expectations. Finding, negotiating, structuring, closing, and integrating acquisitions is difficult. On paper all acquisitions look like 1+1 = 3, but in reality most are 1+1 = 0. Taking this into account, as microcap investors, we should be skeptical when a microcap company we own makes an acquisition.
Michael Mauboussin (@mjmauboussin), Head of Global Financial Strategies at Credit Suisse, co-authored this great report on Capital Allocation [H/T @HurriCap]. In the report he showcased the table below showing the probability of M&A success based on type of deal.
Even though M&A is rarely successful, the irony is that some of the biggest microcap success stories had disciplined acquisition strategies, including: Cisco (CSCO) 200+ acquisitions, Automatic Data Processing (ADP) 100+ acquisitions, Middleby Corporation (MIDD) 50+ acquisitions, Autodesk (ADSK) 35+ acquisitions, MTY Food Group (MTY.TO) 20+ acquisitions, and many others.
This begs the question which was asked by one of our blog readers: When we look at microcaps that make acquisitions, how can a microcap investor evaluate the potential success or failure of an acquisition? To help answer this, I think it’s best to evaluate why most microcap acquisitions fail.
According to S&P Capital IQ, there are 13,332 microcaps traded on US, Canadian, and UK markets. 6,900 (52%) have revenues and 3,200 (24%) have positive operating income. Perhaps the biggest reason why microcap acquisitions fail is the acquirer itself isn’t under sound financial footing. They might be unprofitable or slightly profitable, barely capable of sustaining their own operations let alone integrating another business that may or may not be profitable. I went through this recently with a position where they had a growing profitable business but then acquired an unprofitable business. A year later they liquidated the acquisition after the losses nearly took down both businesses. Worse yet is when two undercapitalized unprofitable companies merge, which I call a POS Merger (use your imagination as to what POS means). You have two small POS’s merging to form one giant POS.
Most microcaps use equity either by issuing shares or raising capital through the equity markets to make acquisitions. They are forced to use equity because they don’t have a choice. It’s unfortunate but true that many microcaps don’t produce enough cash, have the cash on hand, and/or have a long enough track record to acquire debt at attractive interest rates to make acquisitions.
The biggest reason why most microcap acquisitions/M&A strategies fail is because most microcaps have to use all equity for acquisitions, and many microcap management teams are not good capital allocators. Not all CEOs that treat their shares like gold are good capital allocators but almost all great capital allocators treat their shares like gold.
I can’t tell you how many times I’ve heard a microcap CEO’s say, “Well there is no point to being public unless we can use our stock as a currency.” I somewhat agree with them, but there is a time and place for using their stock as currency. Intelligent fanatics know when to use their stock as currency (when it’s expensive and accretive) and when to cannibalize and eat themselves (share buy backs when it’s cheap). I’m reminded of Henry Singleton of Teledyne who made 130 accretive acquisitions when his stock was expensive (>25 PE), and in the 1970s and 1980’s bought 90% of Teledyne’s stock back when it was cheap (<8 pe).< p>
Acquisitive Management Teams Using Equity
Some microcap management teams are very acquisitive. In fact, they discuss their acquisition strategies in their investor presentations and during conference calls. This is fine if the company has the balance sheet to conduct acquisitions. However, if forced to use equity they are basically announcing to larger investors to hold off from buying shares in the open market. Smart money doesn’t buy stock in the open market when they know a big equity raise or share issuance of an unknown size for an unknown purpose is likely. The stocks of such businesses are often stuck for years in a purgatory of sorts of naïve short term investors entering and exiting while real long-term investors move on to other opportunities.
Large “Transformational” Acquisitions Using Equity
Issuing equity for acquisitions can be especially harmful when issuing a large amount of equity. I’ll define large as issuing shares (directly or indirectly by raising capital) >10% of the outstanding shares. Unfortunately, a large percentage of the acquisitions done by microcaps are done by issuing large amounts of equity. When a small microcap company acquires anything, it is often material. In the best case scenario, the integration goes smoothly and the combined company performs very well. The shares are issued in a way that restricts the immediate selling of those shares (leak out provisions on acquired shareholders and management or equity is sold to finance the acquisition to truly long term investors [rare]). The most likely outcome is the synergies were over-played, the performance is “Ok” at best, and you have to eat through a lot of shares once the restricted equity that was issued becomes unrestricted. This is why you see the stock prices of companies that issue large amounts of equity for acquisitions perform very poorly for 1-2-3 years (maybe forever) following an acquisition. As the “Probability of Success” table above illustrates, be very careful of “transformational” acquisitions (aka big dilutive acquisitions) from a business perspective and stock perspective.
Too many Too Fast Using Equity
As discussed earlier, capital allocation is the #1 priority of a management team and intelligent fanatics treat their shares like gold. An area for concern, especially by those companies that must issue equity for their acquisition strategy, is doing too many acquisitions too quickly. There are quite a few acquisitive management teams that can only use equity that don’t have the patience to wait for the stock to digest and revalue shares higher before making the next one. These management teams keep issuing equity at similar or lower stock prices and the stock never has a chance to increase. The market cap of the company might be increasing but the stock price will not (ie dilution), and the more shares that are outstanding the harder it is for a stock to move up.
Let’s keep things simple and remind ourselves of how multi-baggers occur. Sustainable multi-baggers have three characteristics: Long-term revenue and earnings growth with little to no dilution. These same principles hold true for companies that use M&A as an avenue for growth. Below is simple illustration of three microcap companies from yesteryear that turned into 100+ Bagger stocks: Monster Beverage (MNST), MTY Food Group (MTY.TO), and Middleby Corporation (MIDD):
In these 100-bagger examples, you can see the power of long-term revenue and earnings growth with little dilution. MTY Food Group and Middleby Corporation have successfully utilized an aggressive but disciplined acquisition strategy combined with organic growth to produce phenomenal returns for shareholders. Companies that have successful M&A strategies are extremely disciplined. Middleby Corporation’s CEO’s talks about his disciplined acquisition strategy in this case study.
Middleby, MTY Food Group, and other companies that utilized successful M&A strategies when they were microcaps have one big thing in common. They were intelligent fanatic led businesses whose management teams were in most cases the largest shareholders of the company. These management teams didn’t issue tens of millions of shares early on to do transformational or “swing for the fences” acquisitions. They focused on building their companies and making a series of great small decisions, and then doors opened to larger opportunities. Owner-operator management make better decisions because their net worth is on the line (H/T @HorizonKinetics):
Albert Einstein said, “Compound interest is the eighth wonder of the world.” If compound interest is the eighth wonder of the world, then the compounding effect of great decision making is the ninth. A microcap management team that can string together several great decisions in a row can yield huge returns for shareholders. But it all starts with the first great decision. That first great decision could be to say NO to a good acquisition because it wasn’t a great one. The quote below is perhaps Warren Buffett’s best and is a powerful one for investors and management teams.
“The difference between successful people and very successful people is that very successful people say “no” to almost everything.” – Warren Buffett
Microcap investors should be skeptical of dilutive, equity based acquisitions. Early stage microcaps often times don’t have the financial-fundamental horsepower to utilize cash flow, cash on hand, and/or debt for acquisitions. These management teams need to thoughtfully weigh the pros and cons of issuing equity. Many 100-bagger stocks originated out of the microcap arena, and several of them had M&A strategies even when they were small. These intelligent fanatic, owner-operator led businesses took dilution very seriously because their net worth was tied to the stock. These disciplined operators focused on creating growing, profitable, self-funding compounding machines. They creatively structured smaller acquisitions with little dilution and later used debt or equity (only when very accretive) as their businesses matured.
The topic of M&A encompasses many other aspects such as price, structure, incentives, pros and cons of debt, etc, which I’ll go over in later posts. I wanted to first address the biggest problem I see with many microcaps making acquisitions. A microcap investor’s biggest risk is dilution, and a microcap’s worst enemy is a management team that wants to get bigger at any cost.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.