Billion Dollar Fools Games
“There are many well-documented examples of complacency in today’s global capital markets, but one particular alarm, too often overlooked by investors, has been persistently ringing louder. Investor’s insatiable appetite for higher yielding, lower quality debt is the driving force behind the current buyout boom in which private-equity firms gobble up corporate stock and finance the acquisition with heaps of new debt. But as the domestic equity markets cheer the surge in leveraged buyouts, and the size of announced deals gets larger with each passing Merger Monday, the fundamental wisdom behind each deal gets smaller.”
There is nothing permanent except change. While the above quote may be just as relevant today, it was first written in the inaugural edition of the Broyhill Letter published in January 2007. The rest, as they say, is history.
Bull markets have a way of sucking everyone in at the top, as Seth Klarman noted in his most recent annual letter. “Today, stocks and bonds are both in favor; tomorrow, and without notice, this could change. Markets, like hemlines, will rise and fall. The current flavor of the month can turn sour. It is that “turning sour” that can happen rather quickly . . . the problem is, when the market reaches the top of a mountain is when certain groups of investors jump in.”
As illustrated in the chart below, those “certain groups” do not exclude companies themselves. My good friend Nik Modi at RBC recently highlighted the number of billion dollar deals in a research note updating his views on the 2015 Consumer Outlook. Nik believes: “There is an opportunity for investors to take advantage of the stepped up special situations activity we began to see in the back half of 2014.” His best ideas include ENR, where the company’s personal care businesses could be taken out, post-spin. Apparently there are at least a few other guys who still see value in batteries. Note: Buffett’s Berkshire Hathaway buys P&G’s Duracell.
Nik does excellent work on the consumer space and has been spot on with ENR over the years (for what it’s worth, he also had one of the best three-point shots on our high school team despite giving up at least a good foot in height). Unfortunately for us, he was also spot on with his bearish AVP call which we ignored (better luck next time Nik).
That being said, we do tend to agree with his bullish outlook on the opportunity set in special situations. Energizer’s Form 10 is on my desk and on our on-deck list. We are still finding pockets of value in this market although those pockets are getting shallower and often filled with a ball of lint rather than the pleasant surprise that comes with finding a crumpled up dollar bill. In other words, investment decisions cannot be made in isolation. As a result, investments must be made in the context of economic, credit and sentiment cycles all of which are getting long in the tooth as we discussed here. Surging buyouts are yet another cyclical indicator.
History has shown time and again that buybacks and acquisitions are extremely procyclical. Both can be excellent, if not imperfect, measures of corporate sentiment. With activist war chests larger than ever and the velocity of 13D filings only outdone by Hillary’s personal emails, it’s easy to justify paying a high price for a security on the basis that someone else will come along and offer a still higher price for the same investment. But this doesn’t change the name of the game. Selling to a “greater fool” is still a fools game. The chart below shows the last three times “billion dollar fools” showed up in force. We saw this in 2000. We saw this in 2007. And we are seeing it today. Don’t be a fool.