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Investment Madness

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Investment Madness

Here’s a question for you: what kind of business becomes more attractive as an investment proposition the more expensive it becomes?

The answer – apparently – is just about any business that has a strategy of acquiring other businesses.

Here’s how the logic works. Suppose you are the CEO of a company whose shares trade at a price/earnings of say 20x. That’s a robust multiple and demands a certain amount of growth. If your business doesn’t have the necessary organic growth, you will need to deliver the expected growth via acquisition. The good news is that you can buy companies in the same line of business from private sellers, and the multiples paid in the private market are much lower than 20x; perhaps even in the single digits.

This difference in multiple means that you can issue your own shares to acquire the privately held businesses, and achieve an automatic Earnings Per Share (EPS) uplift. The earnings attached to the shares you issue (at 20x) are much lower than the earnings you acquire in return, and so by the magic of arbitrage, your shareholders have achieved earnings (and presumably value) uplift.

Some acquisitions create value through synergy benefits, but for this strategy it is probably better to avoid that sort of thing. Integrating the acquired businesses and extracting the synergy benefits is troublesome, and likely to distract you from the main game. You are probably better off focusing on acquisitions that don’t require much integrating. That way you can do more acquisitions in a given space of time, and ….. achieve more EPS uplift!

This is advantageous for your strategy, as faster EPS uplift will justify a higher multiple being ascribed to your shares, and this in turn will increase the ratings differential between your shares and the businesses you are acquiring. A higher rating means a more magical arbitrage value.

In this way, you should be able to see that the more expensive your company’s shares become, the more effective your growth strategy becomes, and the whole thing becomes a kind of virtuous cycle.

…except that the logic is a tiny bit circular.

If for some reason your ratings were to fall, or private acquisition targets at low multiples were to become scarce, the whole charade might just start to unravel in the same way that it came about. A declining share price could wipe out the value creation potential of your strategy and justify an ever decreasing share price.

Here’s my tip: if you see a broker finding virtue in an elevated price/earnings multiple by pointing out that it facilitates EPS accretive acquisitions, it may be wise to count the seats between you and the exit row.

Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To learn more about our funds please click here.


Tim joined Montgomery as Head of Research and Portfolio Manager of The Montgomery Fund in July 2012. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Before joining Gresham Partners, Tim worked for McKinsey & Company for four years, where he was involved in strategic consulting in both Australia and Denmark.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Greg McLennan

    Hi Tim,

    Looks like being a big day or two for many of us. Obviously, those like me who have a financial interest in SRX will be hoping that the primary endpoint relating to progression free survival has been met but of greater human importance, it would be of great significance to those who suffer the disease.

    Fingers crossed.

    • G’day Greg,

      We now know that based on this trial the products penetration into the first line setting will be limited to off label. There does however remain statistically significant results as the second end point was proven so the salvage market penetration could increase materially. The salvage market is about 100,000 doses compared to the current 11,000 doses. We are currently interviewing oncologists to understand their response. We ‘currently’ believe the market is inefficient and are determining whether there is a big opportunity at the current price. Tim, to update with some comments this week.

      • benjamin.mentha

        I work in town planning and we’ve had a few child care centers that got permits in the last couple of years come back seeking additional child care places. The ones that had permits are usually around 70 places, but apparently the operators are now only interested if they have a minimum of 80-90 places.
        The metrics of the child care sector appear to be changing.

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