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The Competitive Advantages of Berkshire's Acquisition Business

More often than not, acquisitions can destroy long-term shareholder value instead of creating it, given the high likelihood of overpaying as well as the challenging post-deal integration.

Warren Buffett (Trades, Portfolio) is well-known for his disapproval of the serial acquisition behavior among many corporate managers. In his 1995 shareholder letter, Mr. Buffett described another risk inherent in the acquisition process - information asymmetry:

"In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: 'Can you help me? Sometimes my horse walks just fine and sometimes he limps.' The vet's reply was pointed: 'No problem - when he's walking fine, sell him.' In the world of mergers and acquisitions, that horse would be peddled as Secretariat.

At Berkshire, we have all the difficulties in perceiving the future that other acquisition-minded companies do. Like they also, we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking 'just fine.'"

As Berkshire Hathaway (BRK.A) (BRK.B) employs an acquisition-driven growth strategy, Mr. Buffett's acknowledgment of such a "defect" itself reduces the deal risk in our view.

At the same time, Mr. Buffett also elaborated in his letter a couple of competitive advantages of the Berkshire acquisition approach.

"Even so, we do have a few advantages, perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market. Our practice of making this comparison - acquisitions against passive investments - is a discipline that managers focused simply on expansion seldom use."

To avoid overpaying, Mr. Buffett intentionally disregards any possible synergy by comparing the values and opportunity costs between acquisitions and stock investments in the secondary market. At Urbem, while we are by no means against any inorganic growth, it would undoubtedly raise our suspicions if management emphasizes the strategic value (or synergy) of a deal. While we do believe that strategic significance can exist, it might be scarce and highly uncertain, leading to our lack of willingness to pay for it.

We understand that certain businesses inevitably need to acquire others to grow. In this regard, a pre-defined discipline in place would be quite helpful. For example, Chemed (CHE) explicitly lists out the valuation ceiling in terms of price multiples for its acquisition targets:

"In making acquisitions, we have a further advantage: As payment, we can offer sellers a stock backed by an extraordinary collection of outstanding businesses. An individual or a family wishing to dispose of a single fine business, but also wishing to defer personal taxes indefinitely, is apt to find Berkshire stock a particularly comfortable holding."

Thanks to its unique business model, Berkshire has another advantage for making acquisitions which is hard for peers to replicate - paying through its shares backed by a diversified pool of high-quality businesses. This offer is particularly attractive to owners with tax concerns. For example, in the same year of 1995, Berkshire purchased Helzberg's Diamond Shops utilizing a tax-free exchange of shares, which was the only kind of transaction attracting Barnett Helzberg, Jr., the seller.

"Beyond that, sellers sometimes care about placing their companies in a corporate home that will both endure and provide pleasant, productive working conditions for their managers. Here again, Berkshire offers something special. Our managers operate with extraordinary autonomy. Additionally, our ownership structure enables sellers to know that when I say we are buying to keep, the promise means something. For our part, we like dealing with owners who care what happens to their companies and people. A buyer is likely to find fewer unpleasant surprises dealing with that type of seller than with one simply auctioning off his business."

The acquisition cycle at Berkshire is unheard of anywhere else in the financial industry. The company acquires the business, keeps the management, lets them run the firm and has no exit strategy in place. Investors should realize that able and honest management is a rare species in the business world. Management retention builds up momentum and spirit at the acquired business. In 1995, Helzberg's Jeff Comment was the kind of manager that Berkshire wanted to "own." Mr. Buffett admitted, "Buying a retailer without good management is like buying the Eiffel Tower without an elevator."

By contrast, other private equity firms often leverage the business up after the deal, take over control of management and put it up for sale after a few years, trying to take advantage of "greater fools."

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We own shares of Berkshire Hathaway.

Read more here:

  • The Founder Advantage, Pt. 2: Overseas Picks
  • The Urbem Quality Score
  • The Founder Advantage

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This article first appeared on GuruFocus.