An investment philosophy that considers stock market investing as simply another form of business investment will necessarily focus on the basics of business investing, such as cashflows. That is often at ends with how the stock market works.
Case in point is the infamous “non-cash” charge…… Wall Street brokerages and too many investors are delighted to ignore non-cash charges because, well, they are non-cash. It’s worth reminding investors what every business owner knows: that those non-cash impairments more often than not started out as cash outflows, usually for acquisitions. A non-cash impairment of goodwill or asset write down is the accounting equivalent of sweeping up the ashes of what used to be a pile of cash.
Managing large complex organizations entails taking risk. Not all acquisitions will pay off. Even in very successful businesses, many of them will fail. There is no shame in that. But company managers and investors have reason to be skeptical about large acquisitions. The stakes are necessarily higher.
In late 2018, a prominent US FMCG announced a $12.8 billion investment, for a 35% stake, in a rapidly growing company that was taking share from the older, more established enterprise. It valued the acquisition at an eye-popping $36 billion. The deal was unusual in that the payment had already been made, in cash, at the time of the announcement. Initially, the acquiring company’s stake was of non-voting shares. The acquirer would get seats on the board once anti-trust, regulatory approvals were received down the road. In short, $12.8 billion in cash went out the door; non-voting shares in a super-unicorn came in. The carrying value of the investment was $12.8 billion as of 12/31/18, with a similar amount of new debt on the liability side of the balance sheet.
The acquisition didn’t necessarily coincide to the day with the peak in sales by the unicorn, but it was pretty close. During the course of 2019 for a variety of reasons, the unicorn retreated rapidly. As a result, the acquirer announced a series of “non-cash” impairments. The first write off occurred just nine months later, in the amount of $4.5 billion. The second one followed a quick three months later, in the amount of $4.1 billion. So within just over one year of the deal’s announcement, the acquirer wrote off $8.6 billion of the $12.8 billion original investment. That left a carrying value of $4.2 billion on the balance sheet. That amount lasted 9 months. In October 2020, the company wrote off another $2.6 billion. The new carrying value of $1.6 billion is 12.5% of the original amount. The rest had disappeared in just under two years. Wow. That was fast. Ring, ring. Harvard Business School calling. They want their newest case study back.
Investing in publicly traded corporations as a businessperson with a business-like sensibility is difficult. The agency costs are significant. As a minority investor, you vote for the Directors (though you rarely have a choice). The Directors hire the Chief Executive. The CEO hires the senior staff and so forth. And then there is government regulation, input costs, changing market trends, etc. Simply put, unless you are in a position to create the business from scratch or buy it out entirely, there are agency costs down the line. That’s the price one pays to take a minority stake in a publicly traded company. So some errors of judgment by those downstream directors, executives and managers are to be expected. They are not necessarily intentional or malicious. The goal of the business investor is to try to mitigate the risks associated with all those intermediaries. Diversification is one way of doing that. Analysis and decision-making are another. Nevertheless, it is almost impossible to avoid a bad acquisition showing up now and again in your portfolio. The individual investor and many institutional ones are just too far removed from control to avoid it entirely. Still, my experience suggests that most large acquisitions struggle to justify themselves. And the larger the acquisition, the harder it is to make the numbers work. Dear CEOs, please keep that in mind before you go on your next elephant-hunting expedition. We business investors don’t believe in “non-cash” charges.