Acquisition Archives: Winners and Losers

In my last post, I looked at HP's disastrous acquisition of Autonomy for $11 billion in 2011 and its subsequent write off of $8.8 billion. While it stands out as a particularly egregious example of a bad deal, it is unfortunately not the exception. In fact, the evidence suggests that a growth strategy built around acquisitions, especially of other publicly traded firms, is more likely to fail than succeed. To back this statement, you can look at three pieces of evidence:
(a) the behavior of the acquiring company's stock price, around the announcement of an acquisition
(b) the post-deal performance (stock price & profitability) of firms after acquisitions
(c) the overall track record of acquisition-based growth strategies, relative to other growth strategies

The acquisition date: Uninformed investors or Delusional managers?
When an acquisition of a publicly traded company is announced, the attention is generally on the target firm and its stock price, but the market's reaction to the event is better captured in what happens to the acquiring firm's stock price. In the figure below, take a look at the target and acquiring firm stock behavior in the twenty days before and after the acquisition announcement across hundreds of acquisition announcements:

The winner in public company acquisitions is easy to spot and it is the target company stockholders, who gain about 18% over the 41 days. On average, bidding company stockholders have little to show in terms of price gains; the stock price for acquiring firms drops about 2% during the announcement period and about 55% of all acquiring firms see their stock prices go down. Note that while the percentage price drop is small (relative to the price increase for the target firm), acquiring firms are typically much larger than target firms and the absolute value that is lost by acquiring firm stockholders from acquisitions can be staggering. A study of 12,023 acquisitions by large market cap firms from 1980 to 2001 estimated that their stockholders lost  $218 billion in market value because of these acquisitions. While this number was inflated by some especially bad deals done between 1998 and 2000, they illustrate the potential for massive value losses from acquisitions and the reality that one big, bad deal can undo decades of careful value creation in a company.

There is one final interesting statistic that can be gleaned from the announcement date market reaction. If you take the cumulative market value of the target and acquiring firms, just before the acquisition announcement and just after, that combined value increases, on average, across mergers. For better or worse, this is what the market seems to be telling us at the time of acquisitions announcements: it believes that there is value added from synergy or other sources in the typical merger, while at the same time also believing that acquiring firms over estimate the value of the synergy and pay too much.

The long term: Post-deal blues?
The defense that is offered by acquiring company managers, when confronted with the market's negative reaction to the acquisition announcement, is that the reaction is rooted in ignorance. Acquiring company managers claim to have access to information and forecasts that stockholders don't have and argue that they are in a better position to value "synergy" and "control". It is of course true that managers have more information on target firm than their stockholders do, but the proof is ultimately in the pudding. To make a judgment on whether this superior information pays off in superior performance, let's look at whether acquiring firms deliver on the promised synergy and other benefits.
Post-deal stock price performance: KPMG studied the 700 biggest mergers between 1996 and 1998 and compared the stock price performance for a year after the deal was closed to that of the peer group to conclude that 83% of the companies underperformed after acquisitions. Thus, the negative reaction to acquisition announcements does not seem to dissipate over longer periods.  In some good news, KPMG has updated its M&A study five more times since its 1999 study and reports that there has been some improvement between 1999 and 2011. While only 31% of deals made in the last study (looking at 2007-2009 deals) were value adding, that is an improvement over the 17% from the 1999 study:

While this study can be faulted for its short time horizon (it looked at only the year after the merger for improvement), the consensus across many academic studies is that acquiring companies' shares under perform their peer group over long periods (extending 3-5 years).

Post-deal operating performance: The evidence is mixed on measures of operating performance. While there are some studies that find improvements in operating margins after acquisitions, these gains seem to be exist for a subset of acquisitions (hostile seem to do better than friendly) or only for sub periods. McKinsey has looked at mergers over three decades, asking two simple questions of acquirers: (a) Does the acquisition generate a return on capital that exceeds the cost of capital for the deal? and (b) Does the acquisition lead the acquirer to become more profitable than the peer group? In its studies that have spanned three decades, McKinsey found that most acquirers fail at least one of the two tests and that many fail both. 

In summary, if the sales pitch for an acquisition is that it will help boost the acquirer's stock price and improve profitability, relative to the peer group, there is no evidence that either happens, at least on the typical acquisition.

Growing through acquisitions
For better or worse, some companies choose to grow primarily through acquisitions and it is true that some succeed. For instance, Cisco transformed itself from a small technology company to the largest market cap firm in the world (very briefly in 1999) by acquiring dozens of other companies.

Firms are often attracted to an acquisition-based growth strategy, because it seems to offer a speedier pathway to success, but acquisitions are not the only option for growth. A company can develop new products, take existing products in new markets or try to capture a higher market share of an existing market. The question then becomes not whether a company should grow, but the most efficient way to seek out that growth. Drawing again on a McKinsey study of different growth strategies in the consumer goods industry over several decades, we see a disturbing picture:

The payoff to investing in growth is greatest for new-product development, where a million invested in the strategy generates additional value of $1.75 million to $ 2 million, and generates the most bang for the buck (with share prices doubling with relatively small revenue growth of 5-6% from the new products). The payoff to growth investing gets steadily worse across the next four strategies and is worst with acquisitions, where a million investing in acquisitions generates between -.5 million to $.2 million in additional value.

There are shades of nuance that are missed in this aggregate picture. As I will note in a later post, there are subsets of acquisition strategies that do better; buying smaller rather than larger companies, private as opposed to public companies and strength-focused rather than me-too acquisitions. Notwithstanding these pockets of success, it remains true that it is difficult to create value with an acquisition-based growth strategy and it becomes even more so as the company gets larger. In fact, Cisco is a good example of the diminishing returns to acquisition-based growth, as the same strategy that worked to great effect in the 1990s worked against the company between 2001 and 2010.

And the disease is spreading
The scariest aspect of the acquisition disease (which destroys value) is that it is now spreading to emerging markets. Emerging market companies, which used to be targets for richer developed market companies, are now in a position to be acquirers and some of them are targeting developed market icons. Looking at the prices they pay, and the practices they adopt, it is also clear that emerging market companies are making the same mistakes that their developed market predecessors did. A study of the stock price behavior in the days before and after the announcement of 114 acquisitions of US companies by Indian companies  illustrates the problem:

Indian acquirers: Months before & after acquisitions

While the initial reaction to acquisition announcements is positive, market disillusionment with the acquisition sets in quickly and the cumulative returns deplete over time, turning negative as you get to 20 days after the announcement.

Why do companies persist?
Given this history of value destruction, you would think that companies would become more measured in pursuing acquisition-based strategies. That, unfortunately, does not seem to be the case. Not only do we continue to see big, bad deals, but we often see the same company repeatedly making bad deals and the same mistakes repeated over and over by other companies. Not only is there no learning built into the process, but this repeated losing behavior would suggest that there is some collective irrationality at play (a euphemism for insanity) or that the acquisition process is flawed, and in the posts that follow, I will take a closer look at both possibilities. I will begin by by putting the objectives and incentives of the key players in the acquisition process under a microscope, starting with the top managers in both the acquiring and target companies, following up with the "advisors" (investment banks, commercial banks and consultants) on these deals, and ending with the accountants whose job it is to provide information on the deals. I will then look at the mechanics of the process, first focusing on common errors that I see in acquisition valuations and then looking at how best to value "control" and "synergy". I will close with a post on how to improve the odds of success with an acquisition-based growth strategy, drawing on lessons from history.

The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

HP's Deal from Hell: The mark-it-up and write-it-down two-step

I don't think that there can be any disagreement that Hewlett Packard (HP) had a terrible day on November 20. In a surprise announcement, the company announced that it was taking a write off of $8.8 billion of the $11.1 billion that it paid to acquire Autonomy, a UK based technology company, in October 2011, and that a large portion of this write off ($ 5 billion) could be attributed to accounting improprieties at Autonomy. Even by the standards of acquisition mistakes, which tend to be costly to acquiring company stockholders, this one stood out on three dimensions:

1. It was disproportionately large: While there have been larger write offs of acquisition mistakes , this one stands out because it amounts to approximately 80% of the original price paid. 
2. The preponderance of the write off was attributed to accounting manipulation: Most acquisition write offs are attributed either to over optimistic forecasts at the time (the investment banker made us do it..) of the merger or changes in operations/markets after the acquisition (it was not our fault). HP's claim is that the bulk of the write off ($5 billion of the 8.8 billion) was due to accounting improprieties (a polite word for fraud) at Autonomy.
3. The market was surprised: Most acquisition write offs, which take the form of impairments of goodwill, are non-news because they lag the market and have no cash flow effects. In other words, by the time accountants get around to admitting a mistake from an acquisition, markets have already admitted the mistake and moved on. In HP's case, the market was surprised and HP's stock price dropped about $ 3 billion (12%) on the announcement. Put differently, the market had priced in an acquisition mistake of $5.8 billion into the value already and was surprised by the difference.

The blame game
I am sure that this case will be examined and reexamined over time in books like this one, but at this moment, every one involved in the merger is blaming someone else for the fiasco. So, here is a roundup of the suspects:

• Meg Whitman, the current CEO of HP, blamed the prior top management at the company, and said that "(t)he two people that should have been held responsible are gone ".
• Leo Apotheker, the prior CEO who orchestrated the acquisition, claimed to be shocked at the "accounting improprieties" at Autonomy. 
• Michael Lynch, the founder of Autonomy, said that two major auditors had performed "due diligence" on the financial statements and had found no improprieties at the company. 
• Deloitte LLP, the auditor for Autonomy, denied all knowledge of accounting misrepresentations and claimed to be cooperating with authorities. 
• The advisers on the deal (Perella Weinberg & Barclay's Capital for HP, Quatalyst, UBS, Goldman Sachs, Chase & BofA for Autonomy) have all been mysteriously silent, though none have offered a refund of their advisory fees. 

So, who is telling the truth here and who is to blame? Perhaps, the only way to answer this question is to go back to the original deal, which occurred just over a year ago.

Building up to an acquisition price: The original deal
Before we look at the numbers, it is worth reviewing the history of the two companies involved. Autonomy was a company founded at the start of the technology boom in 1996, which soared and crashed with that boom and then reinvented itself as a business/enterprise technology company that grew through acquisitions between 2001 and 2010. Hewlett Packard, with a long and glorious history as a pioneer in computers/technology, had fallen on lean times as it's PC business became less competitive/profitable and due to top management missteps.

On August 18, 2011, HP's then CEO, Leo Apotheker (who had worked at SAP) announced his intent to get out of the PC business and expand the enterprise technology business by buying Autonomy. While the deal making began on his watch, the actual deal was officially completed on October 3, 2011, with Meg Whitman as CEO. If she was a reluctant participant in the deal, it was not obvious in the statement she released at the time where she said that "(t)he exploding growth of unstructured and structured data and unlocking its value is the single largest opportunity for consumers, businesses and governments. Autonomy significantly increases our capabilities to manage and extract meaning from that data to drive insight, foresight and better decision making."

One of the perils of assessing "big" merger deals is that the fog of deal making, composed of hyperbole, buzzwords and general uncertainty, obscures the facts. So, let me stick with the  facts that were available at the time the deal was done (a time period that stretched from August 18, 2011, to October 3, 2011):

1. Acquisition Price: While there have been varying numbers reported about what HP paid for Autonomy, partly reflecting when the story was written (between August & November) and partly because of exchange rate movements (HP paid £25.50/share), the actual cost of the deal was $11.1 billion. 
2. Market Price prior: Autonomy's market cap a few days prior to the deal being announced was approximately $5.9 billion.
3. Pre-deal accounting book value: The book value of Autonomy's equity, prior to the deal, was estimated to be $2.1 billion. (Source: Autonomy's balance sheet from its annual report for 2010)
4. Post-deal accounting book value: After acquisitions, accountants are given a limited mission of reappraising the value of existing assets and this appraisal led to an adjusted book value of $ 4.6 billion for Autonomy. (Source: HP's 2011 annual report, page 99)

The advantage of working with these numbers is that differences between them are revealing. In the figure below, I attempted to deconstruct  the $11.1 billion paid by HP into its constituent parts:

You can see the build up to the price paid by HP as a series of premiums:

1. The accounting "write up" premium for book value: One of the residual effects of the changes that have been made to acquisition accounting is that accountants are allowed to reassess the value of a target company's existing assets to reflect their "fair" value. For technology companies such as Autonomy, this becomes an exercise in putting values to technology patents and other intangible assets and that exercise added $2,533 million to the original book value of equity.
2. The pre-deal "market" premium over book value ($1.3 billion over post-deal book value): Even if accountants write up the value of assets in place to fair value, markets may still attach a premium for growth potential and future investments. As with any market number, this number can be wrong, too high for some companies and too low for others. Prior to the HP deal, the market was attaching a value of $6.2 billion to Autonomy, $3,833 million higher than the original book value of equity and $1.3 billion more than the post-deal accounting book value of equity. 
3. The acquisition premium ($5.2 billion): To justify this premium, HP would have to had to believe that one or more of the following held:  (i) the market was undervaluing Autonomy, i.e., that the true value of Autonomy was much higher than the $ 5.9 billion, (ii) there are synergies between HP and Autonomy that have value, i.e., that there are value-enhancing actions that the combined firm (HP+Autonomy) can take that could not have been taken by the firms independently and/or (iii) that Autonomy was badly run and that changing the way it was run could make it more valuable, i.e., there is a control premium. Even without the benefit of hindsight, neither undervaluation nor the control premium seemed to fit as motives in this acquisition. First, Autonomy was being priced by the market richly in August 2011; the market cap of $ 5.9 billion was roughly 6 times revenues and 15 times earnings and neither number looked like a bargain. Second, for a company that had been as badly run as HP to be talking about inefficiencies at other companies (and control premiums) strikes me as absurd.

The reaction to the deal was negative, a the time that it was done. The analysts and experts were generally down on the deal, but more importantly, the markets voted against the deal by pushing down HP's stock price. Between August 18, 2011 (the date the deal was announced) and October 3, 2011 (when the deal was consummated), HP's market cap plummeted by $15 billion from $58.5 to $43.5 billion. It would be unfair to attribute this meltdown to the Autonomy deal alone, since HP was announcing spectacular failures on so many different fronts, but it would be fair to say that markets did not share HP's hopeful assessments of synergy in this deal.

The cost of accounting impropriety & breaking down blame
Let's fast forward to today. In the conference call on November 18, the CFO of HP attributed the write off of $8.8 billion to two primary sources: $5 billion to accounting improprieties at Autonomy and $3.8 billion to a drop in HP's stock price. The latter rationale does not really hold up since it mistakes cause and effect; the stock price went down because of HP's misstep (though it has made so many that I am not sure which one) and is not the cause of the write off. Thus, it makes sense to attribute the entire write off to the deal. Applying HP's write off of $8.8 billion to the acquisition price of $11.1 billion, brings Autonomy's estimated value (according to HP) back down to $2.3 billion (almost equal to the pre-deal book value of $2.1 billion). In effect, HP is arguing that almost all of the premiums in the original deal (the accounting write up, the pre-deal market premium, the acquisition premium) were not justified.

So, what form did these accounting improprieties take? Based on news reports, HP's contention is that Autonomy was "overstating" and "mis-categorizing" revenues (they were allegedly booking low margin hardware sales as higher margin service/software sales). Assume for the moment that HP is right, and that Autonomy's revenues in 2010 were overstated by 15% and that its true operating margin was the industry average of 31% (and not the 36% that Autonomy was reporting in 2010). Since the accounting misstatements predated the HP acquisition, the pre-deal market value of $5.9 billion should already have been inflated because of the misstatements. Using the pre-deal market value of $5.9 billion as a base, I extracted an expected revenue growth rate of 14.25%. I then substituted in the lower revenues (15% drop) and lower margin (31%) into the valuation and estimated a value for the equity of $4.2 billion. Put differently,  if you buy into HP's story fully, the value effect of the accounting misstatement was $1.7 billion (the difference between the pre-deal market value and the adjusted value)  on the pre-deal value.

HP's argument would be that the synergy premium of $5.2 billion that they paid was also overstated because of the accounting improprieties. Since we do not have access to the detailed synergy estimates (assuming that they were made), we assumed that the accounting overstatement would comprise the same percent of the synergy value it was of the pre-deal market value ($1.7 billion is 28.81% of $5.9 billion) and that half of this value is Autonomy's share (since synergy accrues to the combined firm):
Estimated accounting impropriety portion of synergy value =0.5( 28.81% of $5,200) = $749 million
I know that this may not be fair and that I am going with incomplete information, but here is my breakdown of blame for the $ 8.8 billion write down:

As I see it, everyone involved in this process owns part of this disaster. Leo Apotheker, the CEO who pushed this deal through, gets the lion's share with $4,451 million, though the investment bankers who advised him were his enablers in the process. To the extent that HP is right in its contention that Autonomy cooked the books (inflating revenues and margins), Autonomy's founder/ managers and its auditor (Deloitte) are responsible for $2,449 million in value destruction. That leaves us still with an additional $1,900 million in write offs, which I can attribute to either a deterioration of Autonomy's business in the eleven months since HP took it over (a form of reverse synergy) or game playing on the part of HP, where taking bigger losses now will allow them to claim improvements and look better in the future. In either case, I would hold HP's current management responsible for that portion ($1,900 million) damage. As HP stockholders, though, don't expect any of these parties to offer to cover their fair share.

This deal offers important lessons about headstrong CEOs, the ineffectual accounting for acquisitions and the flaws in the acquisition process that allow bad deals like this one to get through, but this post has become too long to expand on these issues. So, more in my next few posts....


The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

Much ado about liquidity? Lockup expirations and stock prices

Last week shaped up as a big one for Facebook. On Wednesday (November 14), the company faced the steepest of its lockup expiration cliffs so far, with 777 million shares released for sale by insiders. Its two earlier lockup expirations, of 271 million shares on August 16 and 234 million shares on October 29, did cause stock price pullbacks of about 5% and 3% respectively. Consequently, there was concern that Facebook’s stock price would take a beating on November 14, but the stock price climbed 12.6% on that day.

There are a host on intriguing questions that derive from lockups, their expiration and the market reaction to them, and I think it is worth taking a look at them.

The mechanics of and rationale for a 'lockup"
            Facebook is not unique. Most initial public offerings (IPOs) have lockup agreements that prevent insiders (which include owners/founders and VC investors) from selling their shares for a period after the offering. These lockups are not mandated by regulatory authorities but are contractual agreements between issuers and underwriters, with the terms disclosed in the IPO prospectus. While the most common lockup period for IPOs in the US is 180 days, there are quite a few firms that stagger their lockup dates (as Facebook did).  So, why do we see lockup periods in initial public offering? There are at least three reasons for the practice.

1. Skin in the game:  There are many risks that investors face when investing in newly public companies, but one is that the investors and founders of the company will cash out and leave behind a vacuum. Lockup periods ensure that the venture capitalists and owners of a business have skin in the game at least for a limited period after a stock goes public.
2. Signal of company quality: As a related point, having a lockup period makes the offering price more credible for outside investors, since insiders have to wait to sell their shares (rather than dump them at the offering price). A study of British IPOs found that longer lockup periods are associated with better performing IPOs (both in terms of profitability and stock price performance). In fact, it is worth remembering that Facebook, in its pre-offering hubris cut the lockup period to three months for some holders just before the offering date.
3. Stage management of offering: Having a lockup period for insiders also ensures that only a small fraction of the outstanding shares  hit the market on the offering date. This, in turn, enables investment bankers to "discount the price" at the offering and allows them to use the initial offering more as a marketing event leading up to the main event (which is the sale of shares when the lockup period expires). As this study notes, there is evidence that investment bankers and insiders both have an interest in underpricing the offering shares to create price momentum, which can then be ridden (hopefully) to the end of the lockup period. 

Lockup expirations: The insiders' choice to sell (or not)
When a lockup expires, insiders get the right to sell their shares, though they can choose not to sell. While there may be other motives at play, there are three reasons why insiders may sell at the end of the lockup period:

1. Need for cash: Some insiders, while wealthy in terms of the market value of their holdings, a can still be cash poor if the bulk of their wealth is tied up in the shares of the company. If they need the cash (to either fund conspicuous consumption or to pay taxes), they may have to liquidate at least some of their holdings.
2. Diversification : In a related point, the founders and even some of the venture capitalists in a company that has just gone public may find that they have too much of their wealth tied up on that company. Having weighed the desire for control of having a concentrated position against the peace of mind that comes from diversification, some of them may choose to cash out on at least a portion of their holdings and invest that cash elsewhere.
3. Information: Perhaps the trickiest part of the equation is that insiders do have access to information that the rest of the market does not about how a company's operations are performing. If they feel that the market price is too high (relative to their judgment of value), they will be inclined to sell their holdings.

The rest of us get to observe the actions (whether insiders sell at the end of the lockup period and how much they sell) but not the motives. Not surprisingly, we still try to find signals in the actions and react to how much insider selling there is, relative to our expectations.

Lockup expirations: The evidence and analysis
Lockup periods are therefore par for the course in initial public offerings and insiders have multiple motives for selling when lockup periods end. So, what typically happens when lockup periods end? To understand the market reaction when lockup periods expire, let's look at the effects, both positive and negative, of these events:

1. Liquidity effect: In the short term, the end of the lockup period releases shares for sale into the market, creating a demand/supply story that goes as follows: the end of the lockup releases news shares into supply, and holding the demand for these shares constant, this should reduce price. In the longer term, the release of the “locked up” shares to the market increases the shares that are available for trading (the float) and may should improve liquidity. 
2. Information effect: When insiders exercise their right to sell their shares, they are also conveying their views on what they think about the market price. As we noted in the last section, you are more likely to see heavy insider selling, if insiders view the stock to be over valued and less if it is under valued. In particular, markets form expectations about how much insider selling you should observe and if there is less (more) insider selling than anticipated, it is viewed as good (bad) news. 
3. Backstop effect: While investment banks may be under no legal obligation to provide support services beyond the immediate IPO, there is evidence that issuing banks continue to provide at least partial support for an offering until the lockup date. That support can range from buying shares, if the stock price goes into free fall, to favorable recommendations from the issuing banks’ equity research analysts. The removal of the investment banking support system may have negative consequences for stocks. 

Looking at the trade off, the net effect should vary then across companies. You would expect the most negative price impact from lockups ending at small lightly-traded firms (where the near term trading imbalance can overwhelm the long term liquidity benefits), where there are few institutional investors or analysts tracking the firm (making insider trading that much more informative) and where issuing banks have been active in providing support (ensuring that the removal of the backstop will have more consequences.  The effect should be more muted with larger firms that are already actively traded by institutions and tracked by analysts. Since these firms are already heavily traded, the liquidity impact is likely to be smaller, the institutional and analyst following should reduce the information impact of insider trading and the size of these firms will make it impractical for investment bankers to provide more than surface level backstop support.

The studies that have looked at this phenomenon seem to reach consensus on two broad conclusions::
1. The price impact is negative: When lockups expire, stock prices drop. The drop is statistically significant (between 2 and 5%) and there is no rebound from this price drop.  In case you are tempted to try to take advantage of this price drop by selling short prior to lockup expirations, it is too small (relative to transactions costs) and too unpredictable (about a third of lockups end with increases in stock prices) to build a profitable investment strategy around.
2. The trading volume surges: Trading volume increases  on the expiration of lockup periods, with volume increasing substantially both at the time of the expiration and the periods after.  One study finds that the price impact on the lockup expiration is related to the change in liquidity in the post-lockup period, with more positive (negative) stock price reactions correlating with increases (decreases) in liquidity.


Looking at Facebook
Based on the last section, I would argue that analysts who have used the lockup expirations as a rationale for Facebook's stock price performance since its IPO  have been reaching for straws. Facebook is a large market cap firm (market cap > $50 billion), with substantial trading volume and a heavy analyst following. It is not the type of company where you would have expected to see dramatic up or down moves on lockup expirations.

That is not to say that lockup expirations are non-events, since even at Facebook, there have been sizable price reactions to the first three lockup expirations - negative (-5%) for the first one, slightly less negative on the second one (-3%) and positive (13%) for the third.  Rather than search for elaborate rationale for the different market reactions, I would point to price momentum around each of the expirations. The first lockup period expired in the immediate aftermath of a bad earnings report in August, with the stock price already sliding, and the market reaction was negative. The second lockup period expired after the stock had spiked on the third quarter earnings report but was retracing its steps in the days after. The lockup period that expired last week (on November 14) was after the second earnings report, which was viewed as good news, and when the stock had upward momentum. Looking at this small sample, it seems to me that at least in Facebook, insiders have behaved like other momentum investors, selling when everyone is selling and holding if the prevailing sentiment is positive.  If there is a broader lesson to be learned from these experiences, it is that we attribute too much wisdom and knowledge to insiders, at least at young growth companies.  Rather than being ahead of the market in their assessments of value, insiders at these companies are often just as uncertain as the rest of the market and just as likely to follow the crowd. As a stockholder in Facebook now (my limit order did come through), I am less inclined to pay attention to what Zuckerberg thinks or does about the company and more to the fundamentals that will drive its value over time.

Storms and Stocks: Dealing with Disruptive Shocks

Sandy, the super-storm that terrorized New York and its environs is now history, but it left a trail of destruction. As communities around the city and New Jersey dealt with power failures, gas shortage and transportation chaos, I was thinking about the lessons that I learned from the experience and their application to financial markets, which have been buffeted with their own storms for the last five years.

1. Once is an accident, twice is bad luck, but three times is a pattern: For much of the time that I have lived in the United States, power failures were not only unusual but when they did occur, lasted at most for a few hours. However, in 2011, we lost power for several days twice, once after Hurricane Irene and once after a freak ice storm, and this year, we lost power again for a week. While it is entirely possible to attribute these occurrences to chance, it is also possible that weather systems have changed and that the last two years may be more the rule than the exception going forward. The last five years in financial markets have been characterized by “unusual” macro events (banking crisis, Greece, Spain etc.) but they are unusual only because we are viewing them through the lens of recent history (the prior six decades in developed markets). As with the weather, it is possible (and I think it is likely) that these macro crises are not an aberration but are part and parcel of markets for the foreseeable future, and that investment strategies and risk management systems have to be adapted accordingly.  
2. History provides little guidance: When there is a disruptive shock (and the storm definitely qualified), it is human nature to use past history to fill in the gaps, even if it does not quite fit. Thus, my neighbors argued that since train service was up and running a couple of days after the storm last year or the terrorist attacks in 9/11, it was likely to be back up after this one too. In financial markets, investors have used the crutch of historical data (equity risk premiums from the past, PE ratios over time) to evaluate when and where to invest these last five years. In both cases, extrapolating the past would have yielded poor predictions. 
3. Misinformation fills the news vacuum: In the immediate aftermath of the storm, there was an information vacuum where the power and transportation companies had no useful guidance to customers and rumors filled in the gap. With each macro crisis over the last few years, we have seen the same phenomenon in markets, where rumors of deals made and unmade have moved markets substantially. 
4. It is good to have back up systems: About 15 months ago, none of the houses in my neighborhood had back-up generators, as the cost of installing one seemed to be well in excess of any potential benefits. After this storm, I would not be surprised to hear generators starting up at a third of the houses the next time we lose power. The problem, though, is that these generators are themselves dependent upon fuel (natural gas or gasoline) to work and may end up being idle in their absence. Risk managers (at companies and financial service firms) have devised their own back up systems to protect themselves against the “last” crisis but these systems may themselves break down, in the face of the next crisis. 
5. But it is better to design resilient systems: One reason that this portion of the East Coast was hit so hard by the storm was that it was never designed to withstand it. In particular, large power-dependent houses with finished basements, power stations that are close to the ocean or rivers and overhead power lines are all rich targets for storms like Sandy. If these storms are the new norm, we have to think about building houses that are livable without power (those older houses have lower ceilings, unfinished basements and fireplaces for a reason) and a more defensible power system. In investing we have to think about a similar redesign of how we invest, with dynamic asset allocation (reflecting the constant shifts in the macro environment) and a stock selection process that is less dependent upon rules of thumb (many of which were constructed for a past that no longer applies). 

More generally, in the face of the increasing frequency of disruptive shocks, I would pick:

(a)Simpler over more complex systems: Over the last few decades, lulled by the growth of technology and access to data, we have built more and more complex systems (in both day-to-day living and investing) that are dependent upon both. Since disruptive shocks cut off both technology and data, simpler systems will survive and bounce back faster in the face of these shocks. I am glad that my investing strategy is based on intrinsic valuation and that I can value a company with an annual report and a calculator (or even an abacus) and that I am not dependent on access to real time data or computerized trading for investments. I am even happier that I could go two weeks without tracking either the market or looking at the investments in my portfolio, without fear of a meltdown. 

(b) Decentralized over centralized systems: The “hub and spoke” system, where you centralize resources does have its advantages, primarily related to efficiency, at least in normal times. The problem with these systems is that failures at the system’s center can shut the entire system down, as passengers on United and Delta discovered, when their hubs (Newark for United and LaGuardia for Delta) shut down during the storm. Decentralizing these systems may create more coordination headaches during normal time periods but allow for faster recovery after disruption.

I am glad that the storm has passed, that I have power and that I am able to type this post on my train ride home from work. At the same time, I realize that as an investor, there are more storms coming, both from within (the fiscal cliff) and from outside (Asia’s slowdown and the EU’s future) and that I need to become more agile to weather these storms. Time to get to work….

The Yankees' A Rod Problem: Sunk costs and investing

As any baseball fan knows, the New York Yankees have an A Rod problem. Just in case you have no idea what I am talking about, A Rod is Alex Rodriguez, the third baseman for the New York Yankees, signed in December 2007 to a one of the richest sports contracts in history. The Yankees, dazzled by the the numbers that A Rod posted in 2007 and by the possibility that he could become baseball's home run king (with 500 home runs, he seemed to be on a path to beating Barry Bond's record of 762 home runs), signed the then 33-year old to a ten-year contract worth $275 million (with numerous bonus clauses for breaking home run records). The five years since have not measured up to expectations, with the disappointment building to a crescendo in the 2012 post-season, when A Rod's anemic hitting led to his being benched in the last two games against the Detroit Tigers. Now, the Yankees owe $114 million over the next 5 years to a 38-year old third baseman, who is susceptible to injuries and has seem to have lost his home run power  and his capacity to hit right handed pitching.  

What should the Yankees do with A Rod? If they follow financial first principles, the contractual commitment of $114 million that they have already entered into should not be part of the calculus in any decision that they make now. Thus, if they feel that A Rod, based upon his current skill level (and age), is worth only $3 million a year for the next 5 years, they should be willing to consider trading him to another team (assuming he okays the trade) that will offer even a little bit more (say $3.1 million/year) in return, and eat the rest of the contract (about hundred million). Will they do it? I don't think so, because any such deal be an explicit admission that they made a horrendous mistake five years ago. Instead, what you are most likely to see is A Rod at third base for the Yankees, to start the next season, with everyone hoping and praying that he discovered the fountain of youth (at least a legal version of it) in the off season.

The financial principle I was referencing is of course the one of sunk costs and anyone who has taken a basic corporate finance class knows the rule. A cost that you have already incurred or are contractually committed to incur should be ignored in your decision making. That rule, though, is easier enunciated than put into practice and here is a simple exercise to see why:

1A. Assume that you are the manager of a business that is in ongoing development of a new product that will require spending an additional $100 million to bring to completion. Assume that you have just learned that a competitor has come up with a superior product at a lower cost and will be bring it to 

the market at the same time as you will. Would you spend the $100 million?

a) Yes

b) No

1B. Now assume that the same facts as in the prior case but also assume that you know that you have already spent $ 900 million on developing this product. Would you spend the additional $100 million?
a) Yes
b) No

For most of you, I am sure that the answer would have been an easy "No" for 1A, since spending an extra $ 100 million on a product that will not compete seems pointless. For some of you, though, was it more difficult to say "No" to 1B? If so, you are not alone since 80% of managers in an experiment that asked exactly these questions were swayed by the sunk costs into investing in a doomed project. Interestingly, there have also been follow up studies that find that if decision makers were responsible for incurring the sunk costs in the first place, they are even more likely to be swayed by those costs.  In behavioral finance, the capacity of sunk costs to affect decisions falls under what is termed the "Concorde fallacy", named after the ill-fated supersonic jet that the British and French governments poured billions of dollars into, even in the face of clear evidence that it would never be a commercial success, partly because they had already spent so many billions in development.

If you are an investor, you may wonder what this post has to do with you. I think we are all susceptible to the sunk cost problem. To illustrate, let's try a different experiment:
2A. Assume that you are looking at a stock trading at $10/share and that you have valued the shares at $8/share. Would you buy the stock?
a) Yes
b) No

2B. Now assume that you are looking at the same stock trading at $10/share, but that it already part of your portfolio and you bought it at $50/share. If your value per share is $8, would you continue to hold the stock?
a) Yes
b) No

2C.  Now assume that you are looking at the same stock trading at $10/share, but that it already part of your portfolio and you bought it at $2/share. If your value per share is $8, would you continue to hold the stock?
a) Yes
b) No

I am sure that the answer that you gave to question 2A was an unequivocal "No" but was your answer different for 2B? And how about 2C?  (Remember that holding a stock in your portfolio is equivalent to buying the stock....) If the answers were different, why? After all, on an incremental basis, the choice is exactly the same, and an investor who would not buy the stock in 2A would have also sold the stock in 2B and 2C.

The problem is that investors seem to have different sets of rules, one for new or marginal investments, and one for existing investments. Rationally, your decision on whether to keep an investment in your portfolio should be based on whether that investment is cheap or expensive, given its price and value today, and not on what you originally paid for the investment or its value then.  (I know that taxes can create a real issue here, but this problem seems to persist even for tax exempt investors.) However, we are human and almost by definition, we are not rational, and behavioral finance chronicles the costs that we bear. In particular, there is significant evidence that investors sell winners too early and hold on to losing stocks much too long, using a mixture of rationalization and denial to to justify doing so.  Shefrin and Statman coined this the "disposition effect" and  Terrence O'Dean looked at the trading records of 10,000 investors in the 1980s to conclude that this irrationality cost them, on average, about 4.4% in annual returns. Behavioral economists attribute the disposition effect to a variety of factors including over confidence (that your original analysis was right and the market is wrong), mental accounting (a paper loss is less painful than a realized loss) and lack of self control (where you abandon rules that you set for yourself).

So, is there anything that we can do to minimize the disposition effect? I don't have the answer but here are some things that you could consider. I employ the first two in my portfolio and while I cannot quantify how much they have saved me, they have brought me peace of mind.

1. Regular value audits: The easiest path to the disposition effect is denial, where we refuse to look at the investments that we already have in our portfolio because we are afraid of what we may find. In fact, think about how much time we spend trying to come up with new investments to add to our portfolios (it is always more fun to start anew) and how little time we spend on maintenance investing. One practice that I have instituted for myself is that I have to value every company that is already in my portfolio at least once a year. It forces to me to take a look at the company, as if it were a new investment, and decide whether it deserves to stay in my portfolio another year. Since I have about 40 stocks in my portfolio, it does require some discipline but I think it has been well worth the cost.
2. A selling rationale: Even with these value audits, I (like most investors) find it difficult to let go of losers, since selling a stock that has gone down is an explicit admission that I made a mistake. So, I provide myself with cover, especially at year end. For every winner that I sell each year (and I do sell one or two that have become over valued, at least in my judgment), I look for a loser (which is also over valued, in my judgment) that I will unload to reduce my tax exposure. Thus, rather than having to admit that I made a mistake, I can pat myself on the back for a savvy tax trade. Delusional, I know, but it helps...
3. Automated rules: If the first two suggestions don't work, there is a third option, which is to take control of the decision out of your hands. You can put in a stop loss order, specifying that a stock that drops more than X% from your original purchase price, it gets sold automatically. It is a bludgeon, because that stock may very have become a bargain, but you may be saving yourself some bad disposition effect losses.
4. Decision making separation: If it is the unwillingness to admit to your own mistakes that lies at the heart of the "disposition effect", it may be alleviated (at least in part) if the person making the assessment of whether to hold or sell a losing stock is not the person who made the mistake of buying the stock in the first place. Perhaps, mutual fund managers should work in pairs, with one manager responsible for making new investment picks and the other in charge of monitoring existing investments. Impossible to do for individuals, you might say... but I am considering talking to my wife about splitting the investment management role in our family. She can be the stock picker and I could be the stock assessor or vice versa.... One of us gets to make judgments on the other's mistakes.. On second thoughts, scratch that idea..

So, as we watch the Yankees tackle their A Rod problem, it is worth remembering that we all have our own versions of the same problem: a reluctance to admit to our past "investing" mistakes and let sunk costs be sunk costs.

Private Equity: Too disruptive or not disruptive enough?

From my past blog posts, you should know that I am not a political blogger, but Mitt Romney’s background as a key player at Bain Capital has made private equity a hot topic this political season. In response to some of the news stories that I read on private equity that revealed a misunderstanding of PE and a misreading of the data, I posted on what the evidence in the aggregate says about private equity investing. Reviewing that post, I noted that PE fit neither side’s stereotype. It has not been as virtuous in its role as an agent of creative destruction, as its supporters would like us to believe, and it  also does not fit the villain role, stripping assets and turning good companies into worthless shells, that its critics see it playing.

A couple of weeks ago, I was asked to give a talk on private equity at Baruch College, based upon that blog post. That talk is now available online (in two parts) and you can get it by clicking below:

1. https://baruch.mediaspace.kaltura.com/media/Private-Equity+Firm%3A+Friend+or+Foe+of+the+U.S.+Economy%3F+%28Part+1%29/1_fjg9aogk
2. https://baruch.mediaspace.kaltura.com/media/Private-Equity+Firm%3A+Friend+or+Foe+of+the+U.S.+Economy%3F+%28Part+2%29/1_sagki2jm

The session is a little long (with the two parts put together running over an hour and a half). So, feel free to fast forward through entire sections, if you so desire. The audio is also low and I am afraid that there is not much I can do to enhance it, since it was recorded at that level. However, the iTunes U versions of these presentations have better audio and you can get them here:
 https://itunes.apple.com/us/itunes-u/zicklin-graduate-leadership/id556092137?mt=10
I have also put the powerpoint slides that I used for the session for download and you can get to it by clicking here.

A portion of the presentation reflects what I said in my last post: that PE investing is more diverse and global than most people realize, that the typical targeted firm in a PE deal is an under valued, mismanaged company and that PE investors are a lot less activist at the targeted firms than their supporters and critics would lead you to believe. Here are a few of the other points I made during my talk (and feel free to contest them, if you are so inclined):

1. Why private equity? 

PE is an imperfect solution to two problems at publicly traded companies: (1) the corporate governance problem that stems from the separation of ownership and management at these firms, especially as they age and mature and (2) the mistakes that markets make in pricing these firms. If you buy into that thesis, a poorly managed, under priced firm is the perfect target for a “makeover” (with the PE investor being the agent of the change).

2. Who are these PE investors? 

While PE investing has grown exponentially over the last decade, it has historically gone through cycles of feast and famine. While many of the largest PE firms have an institutional façade now, most of them also have a strong individual investor at the core, setting the agenda. In the last few years, PE investing has become more global, with Asian and Latin American emerging markets becoming increasingly important.

3. PE winners and PE losers

In my last post, I noted that the stock prices of targeted companies jump on the targeting and that the payoff to PE investing varies widely across PE investors. Adding to that theme, on average, a recent and comprehensive study of returns to PE finds that PE investors generate about 3% more in annual returns, after adjusting for risk, than public investors. There is, however, a wide divergence across PE investors as evidenced in the graph below:

Thus, the top 10% of PE investors beat public investors by about 36% annually but the bottom 10% of PE investors underperform public investors by about 20% annually. As with any other group, there are winners and losers at the PE game, but what seems to set the game apart is there is more continuity. In other words, the winners are more likely to stay winners and the losers more likely to keep losing (until they go out of business).

4. Is PE a net social good or social bad? 

There are three critiques of PE investing. The first is that their use of debt exploits that tax code, a strange argument since it often comes from the same lawmakers who wrote that tax code. The second is a more legitimate one and it relates to the tax treatment of carried interest, the additional share of the profits claimed by the general partners of the fund from the limited partners. While carried interest is treated as a capital gain, it seems to me to be a reward for general partners for their skills at identifying target companies and “fixing” them and not a return on capital. If so, it should be taxed as ordinary income. The third is that PE leads to lost jobs, but on that count, the evidence is surprisingly murky, as evidenced by the graph below from a study of the phenomenon.

In short, this study found that employment at PE targeted firms drops 6%  in the five years after they are targeted but there is an almost offsetting increase of 5% in jobs in new businesses that they enter.

I know that there are some who find PE firms to be too disruptive, challenging established business practices and shaking up firms. Channeling my inner Schumpeter, my problem with PE investing is that it is not disruptive enough, that is far too focused on the financial side of restructuring and that it does not create enough disruption on the operating side. In short, I want PE investors to be closer to the ruthless, efficient stereotypes that I see in the movies and less like the timid value investors that many of them seem to more resemble. 

The disclosure dilemma: Why more disclosure has led to less information

The last three decades have been the golden age of disclosure, as both accounting rule writers and regulators have pushed companies to reveal more and more about their prospects to investors, both in the US and internationally. Some of this push can be attributed to more activist investors, demanding more information from companies, but much of it can be traced to accounting fraud/malfeasance, where companies held back key information from investors, who paid a price as a consequence. In response, legislators, the watchdog agencies (SEC and its equivalents) and the accounting rule-writers (GAAP, IFRS) have all responded by increasing the amount of information that has to be disclosed by firms. That should be good news for investors, but here are the contradictions that I see:

• If the objective of “disclosure” laws is to prevent the next Enron, Parmalat or Worldcom accounting scandal, it clearly has not worked, since we seem just as exposed as we have always been to these problems. If anything, companies seem to have become more creative in hiding “bad” stuff, in response to disclosure laws, making it more difficult to detect problems. 
•  If the objective is to help investors value companies better, it has not worked either. To me financial disclosures are raw data, when I do valuation, and I must confess that I find financial statements more difficult to work with today than I did thirty years ago, when disclosure laws were less onerous.

So, what gives here? Why have these increased disclosure requirements not worked the magic that they were supposed to? While we can point to lots of reasons, including imperfections in the disclosure requirements, I think that the biggest problem is that the disclosure rules have turned financial disclosures into data dumps. To see my point, take a look at the 10K for a publicly traded company, even a small one, and you will see a document that runs into tens or even hundreds of pages. For instance, Procter & Gamble’s most recent 10K runs 239 pages and it is slim next to Citigroup’s most recent 10K which runs more than 300 pages.  If you are interested in valuing Procter & Gamble or Citigroup, you have to work your way through these pages, separating the wheat from the chaff, or more specifically, information from data. Faced with information overload, it is easy to get distracted by the legal boilerplate (you might as well throw out the entire section that discusses risk) and the trivial details that clutter modern disclosures. In my estimate, less than 10% (and that is being generous) of a modern financial disclosure has any value to an investor and to find this information, here are some things to keep in mind: 

1. Read with focus: Know what information you are looking for, before you start looking for it.  In other words, reading a 10K, just looking for useful information, is equivalent to digging up your backyard, looking for interesting stuff. Your most likely outcome is that you will end up with a mountain of dirt and little to show for your work.
2. Don’t sweat the small stuff: If you are valuing a $ 60 billion dollar company, you can afford to skip over that section that describes in excruciating detail a $25 million real estate lease that the company has entered into or the $50 million lawsuit filed against the company. 
3. Don’t cater to your inner accountant: We know that accounting has its fixations and that financial disclosure often cater to these fixations. Thus, there are large chunks of these documents that are dedicated to how intangible assets have been “fair valued” or goodwill has been “impaired” (a mythical asset that exists only in the accounting world). Since I don’t trust accounting fair value judgments to begin with and goodwill has but a peripheral role (if that) in cash flow based valuation models, I can afford to skip these sections. 

As some of you already know, I do teach a valuation course at Stern and my invite to anyone who is interested in sitting in still holds. Since a key part of doing valuation is learning how to work with financial disclosures, I recently put together a webcast on disclosures, where I used P&G’s most recent 10K to value the company. If you are interested, you can find the webcast with the supporting material (the 10K, my slides and my valuation of P&G). In fact, they are part of set of webcasts I am doing on the nuts and bolts of valuation:
http://people.stern.nyu.edu/adamodar/New_Home_Page/valuationtools.html

I am afraid that things will only get worse for investors. The push towards more disclosure, well intentioned though it might be, is unstoppable and  will create more bulk in annual reports and company filings, and more distractions for investors.

While I am sure that I will be ignored, here are my suggestions to the regulatory and accounting disclosure czars if they truly want to help investors:

1. Focus on principles, not rules: The principles that govern valuation are simple and robust, but they seem to take a back seat to rules when it comes to disclosure requirements. To provide a simple example, capital expenditures should measure what a company invests in its long term assets, whether those assets are tangible (land, building, equipment) or intangible (human capital, brand name, intellectual property). Not only are the accounting rules governing capital expenditures unnecessarily complex but they are internally inconsistent, with different rules governing tangible and intangible investments. (Prime exhibit: the treatment of R&D expenditures). 
2. Less is more: My wife, who is the "organizer' in our house, has a very simple rule for everyone in the family. For every new item that any of us buys, one item has to be removed (given away or abandoned) from our closets. It is an excellent rule, since in its absence, we would undoubtedly hoard what we already have, on the off chance that we might need it in the future. I would propose a similar rule in disclosure. When companies are required to disclose something new, an old disclosure requirement of equal length has to be eliminated, thus preventing disclosure bloat.
3. Target investors, not lawyers: As I browse through financial disclosures, I am struck by how much of the content is written by lawyers, and for lawyers, with the specific intent of shielding companies from lawsuits and/or regulatory backlash. While I understand that companies are gun shy about being sued, and that this protection is necessary,  it may be time to allow companies to file two disclosures, one for lawyers and one for investors. Using P&G as my example, I could construct an investors' 10K, about 20 pages in length, stripped off all the legalese that the full 10K includes.
4. Let accountants do accounting (and not valuation): I know that "fair value" accounting is here to stay, but  I believe that the push is misguided. By requiring accountants to play the role of appraisers, it asks them to play conflicting roles: provide a faithful recording of what has happened in the past (traditional accounting) while also forecasting the future (a key component of making valuation judgments). In the process, I think that we will end up with financial statements that do neither accounting nor valuation well and that investors will pay the price.

Looking forward, investors will increasingly be tested on their capacity to separate the data that matters (information) from the data that does not (noise or distraction). There is an interesting twist (and I thank Bill, who commented on this post for this insight). The increasing complexity of financial disclosure does open up the possibility that investors who can navigate their way through these disclosures and separate information from data will have a competitive advantage over other investors, who give up in frustration.