Story of the month
According to a study by Boston Consulting in 2015, more than half of all company acquisitions destroy value for their shareholders. But here too, more practice makes perfect. According to the consultancy, companies that regularly acquire other companies increase their sales and profits faster than organically growing companies.
So-called ‘M&A compounders’ are companies whose strategy is based on long-term growth and increasing shareholder value through acquisitions. Often, the acquisition targets are smaller, very successful family businesses in their niche, which have a solid financial balance sheet and are characterized by organic growth. However, such companies often lack meaningful reinvestment opportunities for the cash flow generated, and family owners tend to focus on distributions. After a takeover by an M&A compounder, the continued strong cash flow is primarily reinvested in further acquisitions. And because the acquisitions can typically be made at much lower valuation levels compared to the company’s own valuation, the returns on capital are very high and therefore attractive for shareholders. Unlike private equity, the aim is not to make short- to medium-term gains. The acquired companies are intended to become a permanent part of the group. The fact that the target company is not restructured but can continue to operate in its field of business, makes this form of M&A an attractive alternative to private equity for many family businesses.
Successful M&A compounders are well suited to quality- and growth-oriented investment strategies, as they combine high returns on capital and strong cash flows with high growth. Often, these companies are not covered by analysts, which is why there are often positive surprises. When we look for such companies, we pay attention to the following criteria:
- They have free cash flow to finance their acquisitions, so they do not have to borrow to do so.
- They invest in companies with functioning business models that have established themselves in a particular niche.
- They focus on many small acquisitions, not on one large acquisition that transforms the company in one fell swoop.
One example of an M&A compounder is the British company Diploma. It is a distributor of accessories for industry and the pharmaceutical sector. Unlike other distributors, Diploma is not just an intermediary, but also develops customized products for its customers. This fits in with the regular acquisition of specialized industrial companies, most recently a traditional family business that manufactures fasteners for aircraft. With this business model, the company achieves very high returns on average trading capital employed (ROATCE) of 17 to 19%. Another example is the Swedish company Lifco, which markets itself as a ‘safe haven for your business’. But the well-known luxury goods group LVMH also takes a similar approach when it is looking for smaller manufacturers of luxury goods that fit well into its brand portfolio. Such companies are characterized by two features that we value as quality investors: continuous, structural growth and high returns on capital.
