Invest in acquiring companies

There are different arguments made for investing in acquiring companies and target companies. Consider first the arguments that are made for investing in acquisitive companies.

• Invest in small companies that have found a way to speed the growth process. Through the last four decades and especially in the last one, companies like WorldCom, Tyco and Cisco adopted strategies that were built around acquisitions to accelerate the growth process. WorldCom, a small telecomm company, showed that size does not have to be an impediment when it acquired MCI, which was several times its size in the late 1990s. Tyco acquired companies in different businesses, rapidly expanding its business mix and changing its character as a company during the same period. Most famously, Cisco went from being a small company in the early 1990s to briefly being the largest market capitalization company in 1999, with a market capitalization close to $ 500 billion. Investors in all three companies also earned extraordinary returns during the period on the money that they had invested in these companies.
• High Growth and it is cheap (at least in your accounting statements): To understand why investors were attracted to acquisitive companies, you have to begin by first recognizing that most investors like to see growth and most do not care whether that growth comes from internal investments or from acquisitions. You have to follow this up by understanding how acquisitions are accounted for in accounting statements. If accounting rules allow firms to show the benefits of the growth from acquisitions, in the form of higher revenues and earnings, but hide (at least partially) the costs of the acquisitions, it should come as no surprise that acquisitive companies can look very good on a number of accounting dimensions. Earnings and revenues will grow rapidly while little additional investment is made in capital (at least as measured in the financial statements). For several decades in the United States, firms were allowed to use “pooling” when doing acquisitions, if they qualified on a number of dimensions. If an acquisition qualified for pooling treatment, only the book value of the asset of the company that was acquired was shown in the balance sheet and not the market value represented by the acquisition price. Thus if $ 10 billion was paid for a company with a book value of $ 1 billion, the new assets would show up with a value of $ 1 billion (the book value) on the balance sheet but the extra $ 9 billion that was paid would essentially disappear into the footnotes.
• The CEO as genius: One common feature that you often find in acquisitive companies is a high profile CEO, with a gift for self-promotion – Bernie Ebbers at WorldCom, Dennis Kozlowski at Tyco and Jack Welch at GE come to mind. This provides the second rationale that is often provided to investors for buying these companies. These CEOs, you will be told, are geniuses at the acquisitions game, often able to acquire companies at low prices and turn them around to deliver high values.