Month: November 2017

Book Review: HBR Guide to Buying a Small Business

HBR_Buying_Small_BusinessI read the HBR Guide to Buying A Small Business after listening to the authors, Richard Ruback and Royce Yudkoff, interviewed on the Invest Like The Best podcast. The firm I work for does some private equity investing in exactly the types of companies discussed in this book.

Summary

Ruback and Yudkoff teach a course at Harvard called “Entrepreneurship Through Acquisition.” This book draws on many of their students’ experiences. Rather than go out and start up a brand new company from scratch, one can go out and buy an existing business to become an owner/operator. This is less risky than launching a startup.

Many of the entrepreneurs who go this path are highly skilled and motivated, but for whatever reason do not want to work in a large corporate environment. Maybe it’s a desire for control and flexibility. Maybe it’s a dislike of institutional politics.

This book is a guide to the process, from deciding whether to become an entrepreneur through acquisition up through raising capital and closing a deal. In fact, it works pretty well as a private equity primer. Ruback and Yudkoff are basically walking you through a leveraged buyout, though I don’t think they ever explicitly call it that.

Worth mentioning are the key characteristics entrepreneurs should look for in a business:

  • “Enduringly profitable” businesses with EBITDA margins of 15-20%
  • “Boring” businesses with modest growth prospects
  • Businesses with sustainable competitive advantages (a.k.a “moats”), such as high customer switching costs or market dominance in a local or regional niche

The idea is to buy the business for 3-5x EBITDA and structure the transaction so you are targeting an annual return of about 25% to the equity investors. Structurally, this is a very attractive area of the private markets for smaller institutions and high net worth individuals to invest. Big piles of money can’t flood into the space and drive up prices because the deals are too small, in the $2 million to $5 million range for the most part. Imagine SoftBank’s $100bn Vision fund trying to move the needle on performance investing in deals like these!

Who Should Read This Book

Anyone seriously interested in owning, running, or selling a small business would benefit from reading this book. Even if not going the acquisition route it is useful for understanding business models, competitive advantage and strategic financing decisions, as well as the basic principles of financial modeling and valuation. The book is written for a broad audience and is accessible to readers without a finance background.

This book would also be useful for fundamental investors interested in backing an entrepreneur operating a small business, or investing in small public market companies. It is especially helpful in exploring how a small firm can build and maintain competitive advantages over time (a common misconception is that only large cap companies can possess competitive advantages).

On Spurious Precision (With Special Guest Seth Klarman)

One thing I love about investing is that, barring insider information and market manipulation, you must make decisions based on imperfect information. As a high school student I did not care for mathematics (an attitude I profoundly regret as an adult). Reflecting on this, much of what I disliked about mathematics had to do with the fact that it was taught as an exercise in memorization and regurgitation. Many kids I knew who excelled at high school mathematics were simply prolific memorizers of formulas. The whole exercise seemed rather silly to someone who was more creatively inclined. Of course, I have since learned that “real” mathematics couldn’t be any further from rote memorization.

Anyway, financial markets do not reward memorizers of formulas. There is too much uncertainty. Too much change. Too much randomness. Below is an excerpt from Seth Klarman’s incomparable Margin of Safety to elaborate:

How Much Research and Analysis Are Sufficient?

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer. This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit.

This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.

Information is not always easy to obtain. Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. Restrictions on the dissemination of information can complicate investors’ quest for knowledge nevertheless.

Moreover, business information is highly perishable. Economic conditions change, industries are transformed, and business results are volatile. The effort to acquire current, let alone complete information is never-ending. Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor’s informational advantage.

David Dreman recounts “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs… .’ The stock fell from a high of 53 to 11.'”

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. In part this is due to the pressure placed on these analysts to recommend frequently rather than wisely, but it also exemplifies the difficulty of translating information into profits. Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. Merrill Lynch’s pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds.

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.