The cognitive dissonance of M&A

It’s a fascinating aspect of the human brain that we can hold contradictory thoughts at the same time, yet not realise the contradiction. It can even withstand the sunlight of exposure during discussion. Somehow, we can ignore the difficult fact that two of our opinions are mutually exclusive in a self-preserving plate-spinning act, where we tend to each vulnerable opinion as it wobbles under scrutiny.

I’m sure I have my own cognitive dissonance – if anyone notices, please do try to help me overcome it by bringing it to my attention. However, I want to write about an example of such mental plate-spinning that I came across in a recent discussion of mergers and acquisitions in the context of strategy as part of my Executive MBA at Cambridge’s Judge Business School.

It is a well-researched and well-established truth in business and management literature that approximately 75% of mergers and acquisitions destroy value.

The class is made of people from a healthy variety of backgrounds: tech, finance, oil and gas, management consulting, law, medicine, big pharma, and others. Discussion is often centred around finance and banking, partly because of its position in recent discourse thanks to the events of 2007-8, partly due to its importance to the functioning of our capitalist system in general. As such, it is clear from those discussions that many of the cohort believe in the ‘knowledge of the market’.

That is, an efficient public stock market effectively computes all known information about a company to come up with a value for the company and therefore a price for its stock. The stock price reflects all known information about a company and shared opinion about its future prospects, and therefore any change in the price is due to new information or opinions appearing in the public domain. Indeed, the rationale for automated trading by algorithm is an attempt to create an advantage by being able to act extremely fast on any new information. In this model, stock price moves themselves constitute new information too. Incidentally, according to nature.com, there have been 18,520 ‘flash crashes’ on stock markets between 2006 and 2013. The majority of these were caused by automated trading systems, and lasted 1.5 seconds or less (thanks to Wired magazine, UK edition December 2015 issue, for that stat).

So there are certainly difficulties with the idea that a stock price at any particular time tells you anything much, thanks to the magnification of sped-up feedback loops and herding behaviour exacerbated by automated trading. However, in theory it is a defensible position, and in a slow-moving market where stocks had to held for a minimum period of one month (so ultra-fast arbitrage and herding is much more difficult), for instance, it may well be true.

So in theory, the financialised view is internally consistent – if success is measured by financial metrics including expected future financial performance, then the collective wisdom of the stock market is the best available expression of aggregate views of those things, and the aggregate view is much more likely to be closer to reality than a single person’s view (with the significant herding behaviour caveat).

The other financialised view that a group of the class seemed to internalise earlier in the course is that diversification by creating conglomerates is not necessary where public markets (and private investment opportunities) enable investors to make diversification decisions themselves, by buying various different company stocks. So instead of VW buying Tesla to diversify, investors can instead invest in VW and in Tesla in order to achieve a diversified portfolio of investments.

In the financialised worldview, the only rationale for mergers and acquisitions is in order to achieve financial benefit, through synergies that will reduce costs overall, or result in more profitable operation than the two individual companies could achieve on their own. Note that the important measure here is better profitability, not higher revenue. As the saying goes, “revenue is vanity, profit is sanity”.

The cognitive dissonance arose when we came to discussion of the rationale for mergers and acquisitions, when those empirically grounded financialised views give way to a strange thread of magical thinking.

Facebook’s acquisition of Whatsapp has been a recurring question throughout our course. Were Facebook right to pay $22 billion for the messaging app? Financially, there is very little to back it up. Whatsapp did indeed have the foundations of a very profitable company by charging its users $1 each year after the first year for continued use of the app. However, in the half-year prior to the acquisition, it had only $16 million of revenue, and a net loss of $232 million. With 900 million users, eventually a cashflow of $900 million per year on a relatively low cost base would be hugely impressive. However, even factoring in growth to 1 billion users and beyond (which the most pervasive social network, Facebook, has recently managed to reach) and assuming zero costs, the P/E ratio on the acquisition is 22. That’s before even factoring in a discount rate to account for the value of $1 billion in 22 years’ time (which is obviously lower than now, thanks to inflation and opportunity costs).

Anyone reading this want to predict what will be the most popular messaging app in 22 years’ time? Eleven years’ time? Five years’ time? As a reminder, it is less than ten years since the launch of the iPhone.

Anyone predicting with certainty, or even 50%+ probability, what the world of communication will be like in 22 years from now is bound to be wrong, unless they are miraculously lucky. Who wants to bet $22 billion on luck?

However, according to those previously empirical financialists on my course, the Whatsapp purchase is a masterstroke because ‘there are lots of users and somehow they will get monetised’, or ‘Facebook had to acquire the messaging app to defend its strategic position’. The vague notion of ‘strategic reasons’ for justifying acquisitions, let alone mergers, is magical thinking. Given that acquisition of a publicly traded company often involves a ‘price premium’ above the stock price of the target immediately before acquisition, plus often hefty transaction costs (bankers, lawyers, integration costs), there must be significant immediate synergies which enable a higher profit to be made, either by reducing costs or providing more value in the combined entity.

In other words, the acquisition needs to look like this: (a + b) = >((a) + (b) + c)

Company a combined with company b needs to be more valuable that those companies’ separate valuations added together and the transaction costs of price premium and legal and other advice costs (c). That is a high bar, particularly if both companies are publicly traded at the time of the transaction.

If strategic reasons are worth billions of dollars, then the combined value of the companies over time should indeed be more than the value of the separate entities. Facebook’s current earnings per share are $1 per year – roughly the same through Q1-Q3 2015 as they were in 2014 (the Whatsapp purchase closed in October 2014). They are trading at $105 per share. This is share ownership as speculation, which does seriously undercut the ‘knowledge of the market’ argument.

However, if you believe in the market with the financialist mindset, then acquiring for speculative, undefined ‘strategic’ reasons cannot be defended. The Whatsapp acquisition has tied up capital that Facebook had in hand with no method on the horizon for generating even an equal amount of capital, let alone a significant additional return. To claim otherwise is surely to abandon all pretence at measuring success in financial terms, and one cannot be on both sides of this fence simultaneously.

In our Americanised ego-celebrating business culture, the lone genius is venerated. Think of Steve Jobs, Bill Gates, Warren Buffett, and Mark Zuckerberg to name just a few of the celebrities of business over the last couple of decades. Perhaps this is because the real stories of business success are too complex for easy digestion by the human brain wired for simple narrative, or perhaps it is just a cultural choice that we have fallen into. Either way, the amount of faith placed in the decisions of these successful men is bordering on religious.

When we have this level of fervent belief in the infallibility of previously successful people, we close our eyes to how the world changes. Remember those previous world-conquering companies MySpace, Bebo, Friends Reunited, AOL, HP, Kodak, GM – I could go on. At their height, there were many commentators and investors who believed – deeply believed – that dominance was self-reinforcing. That was true for a time, but change happened.

Placing faith in individual judgement over the wisdom of the crowd, and in unchanged dominance for many years, is closer to religion than reason. To have one religious opinion and another, different, reasoned opinion about the same subject matter is untenable. And yet, these extremely capable people on my course are managing to do so through the magic and the madness of cognitive dissonance. Seems there is a healthy future for M&A despite what the numbers tell us.

Written while listening to Feel You by Julia Holter (Domino Recording Co.) and Morning Vox by Rival Consoles (Erased Tapes)

 

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