“Strategic acquisitions” make more business sense than growth by acquisition

Our long-time readers and clients know we’ve developed a number of rules to evaluate stocks and the actions of companies. These rules are all based on what we think of as “financial physics.” They grow out of human nature, which spurs people to take advantage of financial incentives. These rules highlight tendencies, not certainties. But they help us sort through the many opportunities available in the stock market.

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Here’s one rule—we call it a wariness factor—that we often mention:

Growth by acquisition is riskier that internal growth. That’s because the seller of corporate assets almost always knows more about the assets than the prospective buyer. If you make enough acquisitions, you are bound to buy something with hidden problems. Eventually, these problems come out in the open and hurt the acquirer’s earnings.

Growth by acquisition can also warp the thinking of company managers. After all, their pay varies, up to a point, with the value of the assets they manage. This introduces an obvious conflict of interest.

Growth by acquisition also creates profit opportunities for banks and brokers. They collect fees for pre-acquisition research and consulting, and for merger financing. This income can influence the advice they give to their clients.

It’s true that acquisitions may also expand earnings and dividends for the company’s shareholders. Here, though, the gains are less dependable.

In extreme cases, growth by acquisition can work brilliantly for years, then suddenly erupt into a situation like the one that Valeant Pharmaceuticals found itself in a few years ago, when it plunged from $350 to $17. Of course, growth by acquisition was just one of several factors that brought on Valeant’s downfall.

“Strategic acquisitions” make more business sense than growth by acquisition

The riskiest acquisitions may be those that try to beat competitors by buying them out.

Decades ago, most acquisitions aimed at “industry consolidation”. Back then, for example, pharmacy or shoe-store chains might acquire smaller (or, sometimes, bigger) competitors as a way of speeding up growth in the number and floor space of outlets they operate.

The buyer would consolidate or amalgamate the facilities it acquired—merge them with its own, and eliminate the weakest parts of the merged entity. The goal was to gain economies of scale, to cut the merged firm’s average costs and thus increase its profits. With the right public relations support and broker/media attention, plus favourable accounting treatment, a series of acquisitions like this could spur sharp gains in the acquirer’s stock price.

This could also lead to long-term profit gains for the acquirer, some of which spilled over into higher pay for management. However, failure was costly and sometimes led the acquirer into bankruptcy.

Things changed with the tech advances of the past couple of decades. These days, the most successful takeovers are likely to be “strategic acquisitions”. They enhance the buyer’s long-term growth potential, rather than just adding to its facilities.

In the tech era, big companies can gain a scalability advantage from acquisitions. This is more of a choice of expansion opportunities than a conflict of interest.

A company can spend years to recruit a winning team of tech employees, then spend years and make big research outlays with no guarantee of success. Or, it can look for a start-up or junior company that has already assembled the right team, and has already made some progress toward achieving a goal.

Rather than stay independent, the junior may prefer to sell out to a big company than can commercialize the research and shorten the time it takes to bring products to the market, while cutting the risk of failure.

This idea got a big boost with Google’s $1.65 billion takeover of YouTube in 2006, one year after YouTube’s launch. Many observers saw this as an over-priced “trophy buy” at the time, since YouTube had not yet begun bringing in significant revenue. But YouTube now brings in 10% of Google/Alphabet’s revenues, which exceeded $76 billion in the third quarter of 2023, up from $69 billion-plus a year earlier.

Strategic acquisitions can still go sour, of course. But so can internal growth projects. Strategic acquisitions have the advantage of speeding things up—helping progress arrive faster. That’s a boost for the companies involved, and for the economy as a whole.

What do you invest in — growth by acquisition or strategic acquisition?