In the modern corporate world, talk of one listed company acquiring another is almost a daily event. It’s the source of great excitement for investment bankers and the acquiring management team but all too often ends in tears for shareholders.

Takeovers Always Make Sense… Until They Don’t

If company X can purchase company Y for less than it’s true worth it would seem perfectly logical that it should make such a purchase. However, in reality, this is rarely how things play out. What is much more common is Company X pays some sort of exuberant premium for Company Y and then management justify the decision by using terms such as “synergies”, “cost-cutting” and “streamlined”. Don’t be fooled by management’s ability to put a positive spin on their dubious and — dare it to be said — self-serving decision making.

This is not to say that all acquisitions are bad. Of course, some do indeed create value for shareholders. It is unfortunate, however, that many takeovers/acquisitions do exactly the opposite, destroying shareholder value as a direct result of paying too much.

Why Management Often Pay Too Much

Possibly the most often quoted reason for an acquisition is the synergies that the combination of one company with another one promises. The hope here is that the merging of the two companies will result in an overall performance that is superior to what either company could have produced independently.

Secondly, a company’s management is often made up of a number of hard-working, intelligent and enthusiastic go-getters who genuinely believe they can make it work. In most cases, the acquiring company in their overzealous enthusiasm actually believes they are getting a bargain despite the premium valuation their offering price implies.

It could be argued, however, that one of the biggest drivers of acquisitions is the perceived pressure that management feels to be seen to be doing something. Warren Buffett referred to this as the “institutional imperative”, a tendency of management to mindlessly follow in the footsteps of their peers regardless of how foolish the action.

Today’s investment world more than ever thrives on activit. It delivers investment bankers their six-figure bonuses, helps fill the pockets of brokers at the expense of investors and allows managers to be in charge of an ever-expanding business (often resulting in higher salaries and more prestige).

The suggestion that a company would be better off by simply sitting tight and continuing along the steady (if not exciting) path they are on is therefore often in the best interests of no one except shareholders.

The Painful Consequences

All too often in the years following the purchase of another business the acquiring company will announce a ‘one-off’ writedown in tandem with declining profits. In the annual report, management will say something along the lines of “we are proud to report an underlying profit of $10 million excluding a one-off write-down of our retail business”.

In translation, what they are actually saying is “we now admit that we got it wrong by paying far too much for the retail business we acquired and as a result, we now have to significantly reduce the recorded dollar value of the company’s assets to better reflect the true worth of our business”.

The synergies that were promised by management failed to materialise and shareholders suffered as a result. Quite often the CEO that ‘sold’ the acquisition idea to shareholders does not stay around long enough to clean up the carnage they’ve created, leaving with a nice fat bonus for themselves whilst shareholders are left licking their wounds.

Avoiding The Carnage

By targeting companies that grow organically, we can avoid the heartache of watching our hard-earned money being squandered away with overpriced acquisitions from greedy management teams. Two great examples of companies that have excelled without the need for debt-fuelled acquisitions are Flight Centre Travel Group Ltd (ASX: FLT) and JB Hi-Fi Limited (ASX: JBH).

What you are looking for are companies with an enduring competitive advantage ran by competent and trustworthy management with a track record of making sensible capital allocation decisions.

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Disclaimer: Any information contained in this article is limited to general financial/investment advice only. The information has not taken into account your specific needs, goals or objectives, so please consider consulting a licenced and trusted adviser before acting on the information. Please read The Rask Group’s Financial Services Guide (FSG) for more information. This article is authorised by Owen Raszkiewicz of The Rask Group, which is a corporate authorised representative No. 1264179 of Strawman Pty Ltd (ACN: 610 908 211) (AFSL: 501 223).

Disclosure: At the time of publishing, Luke has no financial interest in any companies mentioned.