After several discussions with Compounding Tortoise, we launched this Q&A to share knowledge with our subscribers. There are no commitments regarding the frequency; we will simply share our views when time permits. Therefore, comments will be open to everyone to allow fruitful discussions.
Today’s main question is: What to look for in a great Serial Acquirer?
Heavy Moat Investments response:
For me, a great serial acquirer needs to have a long history and a management team with skin in the game. I prefer decentralized acquirers, who buy great assets and then let them continue their business while supporting them and removing administrative overhead. The key is owning cash-generative defensible businesses and reinvesting the cash to keep the flywheel going. Organic growth is not a requirement (look at Constellation Software), but acquirers like Danaher often cut administrative spending while increasing R&D and S&M spending.
What are the biggest risks?
Dishonest management, undisciplined spending, and leverage can break an acquisition system. The magic serial acquirer flywheel only works if cash flows are reinvested at high returns on invested capital. It’s easy to spend money; it’s hard to make a return. Undisciplined spending can result in leverage, too, if the company piles on debt while earnings grow slower. The same goes for diluting shareholders for bad deals.
What’s my top pick?
I prefer established serial acquirers. If we go by portfolio allocation, my top picks are Danaher, Constellation Software and Lifco. All of them are large and established leaders with a decentralized approach and reinvesting all of the cash flows generated by operations. However, all of them aren’t too cheap because the market knows the quality of the business.
Compounding Tortoise response:
What to look for in a great Serial Acquirer?
The best serial acquirers are run by very competent and honest management teams who prioritize entrepreneurship and corporate culture above short-term thinking. As their collection of subsidiaries grows, decentralization is the ultimate way of providing ever-lasting autonomy to the acquired entities. Therefore, serial acquirers don’t just have to be financially strong, but they should also have a durable cultural spirit that’s very hard to replicate. To be successful, serial acquirers tend to pick defensive businesses with low capital intensity, a high internal ROIC, strong profitability and organic growth areas. After all, sustainable earnings growth starts with protecting the principal. You simply don’t want to be too aggressive (e.g. the Swedish Storskogen) nor do you want to run your serial acquirer too conservatively (in which case cash flow compounding will disappoint investors).
What are the biggest risks?
We’ve undoubtedly been through a lot of volatility over the past several years. Difficult comps, investors extrapolating past growth rates (thanks to margin expansion), some delayed M&A dealmaking in 2022 and the potential resurgence over 2023-2024… these are just a couple of factors that have made it more challenging to properly model potential IRRs for serial acquirers.
Just look at how 2022 unfolded: recession fears, rising interest rates, spiking inflation and above all stalling M&A execution (especially in the industrial serial acquirer space) caused many investors to doubt the efficacy of the serial acquirer playbook. As we’ve stated multiple times in our webinars, there’s a sizable opportunity cost of not being able to reinvest excess cash flow at good returns.
And that’s precisely what allows serial acquirers to deliver great returns: elevated reinvestment rates (oftentimes 80+% of cash flow from operations) throughout the whole cycle. Postponing investment decisions which cannot be compensated for by stronger organic revenue growth and margin tailwinds is likely to result in a severe multiple derating. After all, why would you be paying up for a company with fewer growth opportunities?
What’s my top pick?
Niklas and I are on the same page: we’re scratching our head about today’s lofty multiples for some of the best serial acquirers. In fact, we trimmed our Lifco position a couple of days ago as we deem current implied market expectations to be too rosy. There’s been a lot of chatter around the seemingly low multiples it has recently paid for acquisitions. We wrote a piece about it:
As we lap this period of strong margin expansion for both Lifco’s existing and new incoming subsidiaries, we’d expect investors to ultimately rightsize their expectations for IRR on future M&A. To be clear, we didn’t sell out completely because of Lifco’s unparalleled focus on profitability and best-in-class management team. Let’s see how much farther they can flex the profitability muscle. For sure, we’ll be happy to scoop up more shares during the next correction whenever we feel valuation will allow for generating our base IRR of 12%.
Notwithstanding their current valuations, we expect VMS serial acquirers such as Constellation Software and Topicus to outpace industrial serial acquirers, thanks to their far less cyclical organic revenue growth, favorable cash flow dynamics (negative working capital (deferred revenues)) and relatively un-levered balance sheets.
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