The Rebel Allocator

by Jacob Taylor

  “I do,” I said.

  “Eventually you run out of your own cash and people who are willing to loan you more money. So what does that leave you with?”

  “Equity?” I guessed.

  “That’s right. The first thing you must understand is that equity--stock--is like having your own currency. If you issue shares for an acquisition, it’s like printing your own currency. At the same time, you are effectively selling part of your business. Therefore, a sound rule of thumb is that you never issue shares unless you receive as much intrinsic business value as you’re giving up.”

  “I think I follow, but can you give me a concrete example?”

  “Sure,” Mr. X replied. “Let’s use a very simple example from my youth. Say you’re in charge of your family’s 100 acre farm. You decide to merge your farm with your neighbor’s fifty acre farm into an equal partnership. You are now in charge of 150 acres, which is nice to talk about at BBQs, but your family’s ownership of land and the crop yield has actually gone down by twenty-five acres.”

  “From 100 acres down to 75,” I said after pretending not be counting on my fingers.

  “You’re now in charge of 150 acres, but are you really much of a hero?” he asked.

  “No, you were inflating your ego at the expense of your family,” I said.

  “There are obviously other factors in this decision, but you see the BBQ factor all the time in Corporate America,” he said. “You should always ask yourself if you would sell one hundred percent of your business on the same basis as you’re considering issuing equity.”

  “I see, so could you say that if you issue shares for less than intrinsic business value, you are harming your current family of shareholders? And if you are able to issue shares at above intrinsic value, you might actually be benefiting them?”

  “That’s right, Nicky!” he said. “I’m happy to hear you’re thinking about the shareholders. If you’re able to use your stock that’s priced at twice what you know it’s worth to acquire a company for half what it’s worth, it doesn’t take a genius to figure out you stand to add a lot of value for your shareholders. That’d be the equivalent of using fifty of your family’s acres to acquire 100 of your neighbor’s acres. I have to warn you now, few think this way. They want to get the most acres under management, regardless of how it might hurt those they’ve promised to serve.”

  “You do earn that ‘rebel’ nickname, don’t you?” I teased. “What are some other ideas to keep in mind for M&A?”

  “Here’s a good one,” he said. “Never trust pitch books put together by investment bankers. It’s funny--they can give you precise numbers for what a business will earn ten years into the future, but they can’t tell you what their own business will earn next month. That reminds me of a story.”

  “I love your stories...” At this point my burger and fries had arrived at the table. I tore into them while Mr. X continued talking. Everyone was right; the fries were exceptional. Piping hot, salty, crispy on the outside, smooth on the inside.

  “A man has an ailing horse,” Mr. X said. “He takes it to the vet and asks: ‘Can you help me? Sometimes my horse walks just fine and sometimes he limps.’ The vet replies: ‘No problem--when he's walking fine, sell him.’” With this Mr. X laughed as heartily as his feeble body would allow and paid the price with a vicious coughing fit. It was bad enough that restaurant patrons looked on with concern, wondering if they should call for help. I nodded to them in reassurance, hopeful that it would pass soon. I saw more crimson on his handkerchief and my heart sank.

  “I see,” I said after the spell had subsided. “Others might only be looking to sell their business horses when they’re walking well, not when they’re limping. So always buyer beware.”

  “That’s right,” he said before taking a few deep breaths to regroup. “When you look at the historical data, the average premium paid has been around fifty percent above market prices. Because of that, as a general rule of thumb, most deals benefit the target company’s shareholders at the expense of the acquiring company’s shareholders.”

  “So the seller usually wins?” I said.

  “Yes, the acquirer overpays, often due to the overoptimism we talked about before. Here’s something else: CEOs are herd animals. They travel in packs and emulate each other, including when it comes to M&A. There’s a first-mover advantage to being early in the cycle because there are more higher quality targets, fewer competitors, and usually lower valuations early on. Beware buying anything late in the cycle when everyone wants in. Usually the biggest and most colossally stupid activity occurs late in the game, near the top.”

  “What the wise man does in the beginning, fools do in the end,” I said.

  “Yes, there’s even this phenomenon called the ‘skyscraper index,’” he said.

  “What’s that?”

  “There exists an odd correlation between a city setting a new record for the tallest building in the world and that city’s real estate market crashing shortly thereafter. It happened with the Empire State Building in 1929, Sears Tower in 1973, Dubai in 2009. Having the tallest building is good for BBQ bragging rights. The biggest mistakes show up at the top of the cycle when optimism is running wild. And don’t forget,” he added. “When you are considering acquiring a company, think back to our conversation at the empty lot and the different ways to put a roof over the customers’ heads.”

  “I know what you mean,” I said. “Ask yourself, is it a better deal to get the roof through acquisition or potentially building it yourself? Or even some other creative means.”

  “That’s right. And never participate in auctions,” he said, shaking his finger at me. “You’ll overpay when bidding against others. Bidding wars are bad news for acquiring shareholders.”

  “So are you thinking about acquiring this restaurant chain?” I asked conspiratorially.

  “I’m considering it,” he replied in hushed tones. “There are some obvious cost synergies and a lot of non-strategic expenses that we could wring out of their operations to improve profitability.”

  “So what’s holding you back?” I asked.

  “I’m worried that we’d be paying too much,” he replied. “I don’t think we have a big enough margin of safety.”

  “What does ‘margin of safety’ mean here?” I said.

  “It originated as an engineering concept,” he said. “When engineers build a bridge that’s rated for 10,000 pounds, they only let trucks that weigh up to 5,000 pounds use it. There’s a built in margin of safety, just in case. You don’t go near the edge.”

  “Makes sense, but what does that have to do with this burger joint?” I asked.

  “Well, what if I’m wrong on what I think this business is worth?” he said. “Imagine if I thought it was worth one hundred dollars, but I was wrong and it was only worth seventy-five. In order to leave myself a margin of safety, I’d only consider buying when I can pay fifty dollars. Then when I’m wrong, it can still work out OK.”

  “I can see how waiting for half-off deals would require a lot of patience,” I said. He touched the tip of his nose with one index finger and pointed the other one at me, signaling I was right. Maybe he was just conserving oxygen.

  “One last thing,” he said. “We started this conversation talking about cash on the balance sheet being used for acquisitions. I believe a company’s balance sheet should be run conservatively, even if it means slower growth. I’ll admit, there’s a redundancy to carrying extra cash and very little debt. Yes, it’s expensive to maintain and I bet your MBA professors would say it’s suboptimal. And I know Big Rock would vehemently disagree with me. But we have two kidneys for a reason--increasing our chances of survival. In the business case, we’re talking about more than just the company’s survival. Well-run corporations serve a critical social function. They need to be financially strong enough to act as economic shock absorbers to protect employees, suppliers, and customers from the volatilities of capitalism. Free markets can
do strange things to find the right price level. It’s unfortunate, but it’s still the best system we have for coordinating human action. You need a conservative balance sheet to be a healthy shock absorber. Business done well actually protects the little guys from natural fluctuations.” Another pang of cognitive dissonance. I couldn’t fight it--each trip to Wichita chipped away at my distrust of capitalism. What are you doing to me, Mr. X?!

  A thought crossed my mind: why was Mr. X doing research on a competitor when he seemed to be so close to Death’s door? Why would this be a worthwhile use of his limited time left on Earth? The answer sprang to mind as quickly as the question had formed: business was what lit him up inside. It was his passion and seemed to roll back the clock. Or at least pause time. Business was all he had in this world.

  I found myself feeling sorry for my billionaire friend.

  CHAPTER 33

  My next trip to Wichita would prove to be my oddest yet. I received my customary quote a few days before my flight:

  “In allocating Berkshire’s capital, we ask three questions: Should we keep the capital or pay it out to shareholders? If pay it out, then you have to decide whether to repurchase shares or issue a dividend. To decide whether to retain the capital, we have to answer the question: do we create more than $1 of value for every dollar we retain? Historically, the answer has been yes and we hope this will continue to be the case in the future, but it’s not certain. If we decide to retain and invest the capital, then we ask, ‘What is the risk?’, and seek to do the most intelligent thing we can find. The cost of a deal is relative to the cost of the second best deal.” -- Warren Buffett

  My flight was delayed, and it was already dusk when I arrived. I was to report straight to Mr. X’s house. My taxi battled the stream of traffic escaping downtown toward the sleepy suburbs of Wichita. We wove down side streets into a tree-lined neighborhood. The houses were nicely built brick structures, but not what you’d ever imagine for a billionaire. We pulled in front of a house that looked remarkably unremarkable. I double-checked the address; sure enough, it was the place. I paid the taxi and hopped out into the cool evening air.

  There were lights on throughout the house and cars parked on both sides of the street. As I approached the front door, I could hear the din of voices mingling into a dull roar. There was clearly a party happening. I knocked, and after a few beats, someone I didn’t know answered the door. I nodded apologetically and entered without a word.

  Mr. X’s house was appointed with well-worn craftsman style furniture. It wasn’t fancy, but it had a timeless appeal to it. Sort of like the old man himself. I made my way to the living room where I found the critical mass of the party. I noticed Mr. X propped up in a hospital bed in the middle of the room, chatting with a few elderly gentlemen.

  Cathy noticed my arrival and came over with a hug. “I was worried you weren’t going to make it,” she said, squeezing the life out of me.

  “Sorry, there were mechanical issues with my plane,” I said, after regaining my air.

  “That’s OK,” she said. “You’re just in time for the main event. I’m not sure if you know why you’re here, but in case it isn’t obvious, this is a living funeral for Mr. X. Although I much prefer the term celebration of life,” she said. “He didn’t want this, but when I told him it gives those we leave behind a sense of closure, he eventually gave in.”

  “You can be very persuasive,” I said. Cathy chuckled.

  “There’s food in the kitchen,” she said. “Cootie hamburgers and fries, of course. We even brought in a milkshake machine. Help yourself.” With that she returned back to her previous conversation. I was starving after a long day, and Cathy’s words were music to my ears. I reappeared from the kitchen with a plate full of food and found a place to sit and eat. I was only a few bites in when Cathy hushed the crowd.

  “Thank you for joining us,” she addressed the room. “We’re all here to pay tribute to an amazing man.” Mr. X writhed slightly in his bed. It was unclear if his discomfort was due to illness or the crowd’s attention. She continued, “Mr. X has been like a father to me…” Cathy was choked up and stared down at the floor for a few moments as she regained her composure. “Sorry, this is supposed to be a celebration,” she said with a little laugh through the tears. “Mr. X has been like a father to me,” she restarted. “And I’m not sure what we’ll do when he’s gone. Well, I know what I’ll be doing... going on a long vacation. And since I won’t be running all his errands, I’ll have a lot more free time.” Everyone laughed, knowing the burden Cathy shouldered. “Joking aside, I was a young single mother, no education, no credentials, no future, when Mr. X took me on as his assistant. There were more qualified candidates, and I’ll never understand why he chose me. He mentored me and gave me space and encouragement to grow. I’ll always feel overwhelming gratitude that he took a chance on me. Thank you, Mr. X,” she said. Cathy leaned down to the hospital bed to kiss his cheek. “Now, who wants to go next?”

  It was quiet for a few beats. Eventually a brave soul raised his hand and told a similar story of Mr. X believing in him when no one else did. How Mr. X took a chance on him, and how it defined the trajectory of his career. Now that the seal was broken, a steady flow of such stories came forth. Some shared funny business predicaments that Mr. X helped them out of. Mr. X was also the butt of several good-natured jokes.

  All of the stories were related to business. His personal life was conspicuously absent. Were any family members even here? His work life really was everything to him.

  Eventually the stream slowed to a trickle. Mr. X raised his hand feebly. “I want to thank everyone for coming and sharing their stories.” A coughing fit overtook him. We looked on in concern as we waited for him to recover. “It means a tremendous amount. You’re all important to me... some more than others.” Always the jokester. “I’ve had a good life. I honored my father’s wishes and did the best I could to be useful and run the restaurant. Now that burden falls to you. I know you’ll do an even better job than I did. Now get out, this old man needs his beauty sleep.” He shooed away with his hand and rolled slowly onto his side and seemed to already be asleep. I guess the old man wasn’t much for sentimental speeches.

  People started shuffling toward the door, finding their coats, and saying their goodbyes. Cathy caught up with me and told me to stick around. I hung back until it was just me, Cathy, a snoozing Mr. X, and an in-home nurse who must have been hiding in a back room.

  “I hope you don’t mind hanging around for a bit,” Cathy said. “He usually doesn't sleep for more than an hour or two at a time. He told me it was important he speak with you.”

  “No problem,” I told Cathy. “I’ll catch up on some work while I wait.”

  “Thank you,” she said. “There is a spare bedroom down the hall that is all ready for guests. You can stay here tonight.”

  I thanked her and I settled in to half-heartedly peck away at my homework. I wasn’t in the mood. I got up and wandered around the house, finding Mr. X’s office. It was similar to the rest of the house: solid but not flashy. I glanced around without going in too deep and invading his privacy. There were books everywhere. There were several framed pictures of Mr. X shaking hands with business people and dignitaries I didn’t recognize. Slowly, I meandered back to the living room.

  “See anything interesting in there?” Mr. X asked quietly, but still startling me.

  “Sorry, I was just curious what the office of a billionaire looks like,” I replied.

  “Not that impressive, right?” he said. I just nodded and smiled. “How’d you like my party?”

  “It was great,” I said. “I loved hearing all the old stories. You’ve made a difference in a lot of people’s lives.”

  “I’ve always strived to give more than I take. I believe the way I could do the most to help my fellow man was to do good through business. Truth be told, I hate being the center of attention like that,” he said. “The spotlight makes me nervous. M
y mother would have beat me red with her purse if she found me showboating in front of a crowd.” He laughed and coughed mightly. I felt helpless.

  Mr. X’s nurse peeked her head out as his cough was subsiding. She made her way to his bed and attached supplemental oxygen tubing to his nose. “This should help,” she said with a pat of his chest.

  “Thank you,” he said, drawing in labored breaths. She disappeared again as quickly as she’d appeared. It was comforting to know that I had help should a medical emergency arise. I’m not the right guy for that kind of responsibility.

  Once his breathing settled, Mr. X continued. “I wanted you to stick around so we could cover some more material. I don’t have the energy to help others like I once did. But I want to give you as much ammo as I can to help you with this book. What you write will be important, Nicky. You’ll have to inspire people into thinking for themselves and rebelling against the status quo.”

  “Always the rebel, eh Mr. X? I feel like I’ve learned a lot in our time together,” I said. I was feeling an uncomfortable mixture of awe and uncertainty, with a smattering of pride mixed in that he trusted me with such a weighty responsibility.

  “But not enough yet,” he said. My internal balloon sagged a little with his comment. “Shall we get started on this visit’s lessons and see if we can make up ground?”

  “Only if you feel up to it,” I said, sitting down next to his bed.

  “You just try to keep up.” I patted his inert leg. “One of the things that’s missing today in corporations is a feeling of partnership between shareholders, the board of directors, and management. If more CEOs viewed their shareholders as business partners, they’d do things a lot differently.”

  “Like what?” I asked.

  “Let me ask you,” he said. “If a CEO viewed it as her job to take care of her shareholders, at what price would she want her company’s stock to trade?”