How to find UK takeover targets

The book in question (and which I highly recommend to any budding screeners) is The Acquirer’s Multiple by Tobias Carlisle. As its title implies, the book’s “screening” element boils the entire investing process into one simple metric. That, in turn, echoes its author’s philosophy.

Carlisle points out that modern markets are very good at sniffing out economic profitability. Unfortunately, the ability to spot companies capable of consistently sustaining high returns on capital, year after year, is much trickier, because truly ‘quality’ businesses probably account for fewer than one in 20 stocks. Far better, reckons Carlisle, that we acknowledge this challenge from the jump, and instead focus on what we can control, which is to pay as little as possible for a business.

This is where the eponymous multiple comes in. To regular followers of our screens, the metric – a stock’s enterprise value to operating profits, or EV/Ebit – will also likely be familiar. It pops up in many of the larger data tables that appear in these pages, as well as several other screens.

One of those screens is Magic Formula, which we’ve been following in a UK context for more than 13 years. Like this week’s methodology, the Magic Formula condenses an entire stockpicking strategy into a single equation and is closely associated with the book through which it was first introduced, Joel Greenblatt’s The Little Book that Beats the Market.

Where the Magic Formula differs is its combination of two metrics. While EV/Ebit is used to hunt for value – by comparing the total capital invested in a business to its profits – Greenblatt combines a stock’s cheapness score with its quality, which he defines as the ratio of Ebit to tangible assets (or how much profit a company can generate from its finite, physical assets). In doing so, Greenblatt sought to turn Warren Buffett’s ‘wonderful business at a fair price’ maxim into a quantifiable measure and a repeatable process. Over the years, it has been relatively successful when applied to the UK market.

Like Greenblatt, Carlisle sees the value in contrarianism, and backing stocks in which the market has lost faith. Unlike Greenblatt, Carlisle is less focused on the irrational swings in stock prices than the tendency of underperforming sectors to become starved of capital, and eventual rebounds in earnings for survivor stocks. For this reason, he places a much bigger emphasis on mean reversion.

The evidence appears to back up this value bias. In The Acquirer’s Multiple, Carlisle shows how an investor solely focused on the stocks with the lowest EV/Ebit ratios would have outperformed not only equity markets, but also the Magic Formula, in the 45 years to 2017. That trend was seen both in the US, Europe, and the UK, and adjusted for size (though in back tests, relative and absolute alpha was strongest when it focused a universe of all stocks with a market cap above $50mn (£40mn)).

For the stock screener, such simplicity is seductive. We don’t need to use metrics in combination, so we avoid the trade-offs this often means for portfolio size. All that’s required is a raw faith in the 30 best-scoring stocks on one simple measure. Considering Carlisle already offers screening tools focused on North American stocks, I figured it might be worth applying the same principles to that home of deep value, the UK – where takeovers, often of very cheaply-rated stocks, are on the rise.

What, then, could go wrong?

One multiple, a few kinks

The first issue is the metric’s recent decay. My hunch is that in the seven years since The Acquirer’s Multiple was published, its edge may have waned. Certainly, an unyielding belief in value stocks has fare much less well in the market Carlisle (and most investors) care about most: the US. Not only have the best-performing stocks of recent times carried some of the highest EV/Ebit multiples, but they have invariably been among the largest in the index, too. Over the past five years, for example, the Acquirer’s Multiple of the largest listed stock on planet earth – Microsoft (US:MSFT) – has routinely hovered above 25, and slightly above an already high sector benchmark.

Second, the evidence from our own value screens is that stocks can stay cheap (or get even cheaper) for years. Occasionally, such anomalies get spotted by financial or corporate buyers. This year’s acquisition of the profitable and cash-rich sofa-carpet showrooms group ScS, on an acquirer’s multiple of just over five, is one such example. But generally, low EV/Ebit ratings aren’t always the spur to takeover activity that you might expect.

Nor, on the other hand, do we ever really see those early canonical Warren Buffett ultra-deep-value situations that The Acquirer’s Multiple dives into (albeit largely for illustrative purposes), in which the Sage of Omaha unpicked deeply dysfunctional corporate governance to unlock balance sheet value. Even in the UK, companies tend not to trade at discounts to their cash position. Even if they do, it can be hard to do anything about it unless you’re a hedge fund.

Carlisle is at least candid about the method’s appeal. As he outlined in a speech at Google several years ago, “ignore quality [shares]” is a poor marketing strategy for a fund manager, even if hated companies tend to outperform the adored in the long run.

A bigger question, for someone trying to apply a blunt metric to a very wide array of stocks, is whether the metric’s simplicity can nevertheless lead to false positives or suspect readings.

Let’s start with enterprise value (EV), which is market capitalisation plus debt plus preferred stock, minority interests and pension liabilities (but excluding lease liabilities), less cash.

The first time I applied the metric to stocks in the FTSE All-Share, my screen suggested Barclays (BARC) had a negative EV of £125bn – some way off its market capitalisation of around £28bn – owing to FactSet’s treatment of the lender’s net debt, preferred equity and minority interests. A less dramatic, though still tricky, example is Bridgepoint Group (BPT), whose £1.4bn of collateralised loan obligation (CLO) assets and cash are treated as liquid cash and therefore deducted from market cap, despite their exclusion from the private investment group’s own definition of current assets – and the cash portion being “legally ringfenced” and therefore “unavailable for use”.

As such, we need to approach some enterprise valuations (and therefore Acquirer’s Multiples) in the table below with a bit of caution.

While a non-IFRS accounting measure, operating earnings instinctively seem like the easier number to define. Take revenue, and reduce from it the cost of goods sold, general and administration expenses, plus other overheads such as marketing, R&D, depreciation, and other operating expenses.

However, should we use estimates (for a clearer picture of the future) or reported numbers (about which we can be more secure)? And what about adjustments?

On the former, I’m with Greenblatt: better stick with the known than the possible. To the second question, Carlisle prefers adjustments, as they smooth the ‘one-off’ hits to income. Of course, executives often like to present adjusted figures, too, either because they think it provides a more accurate reading (or, because it allows them to bury some important costs of running the business).

The fact that adjustments sometimes end up disguising a company’s ‘true’ profitability means we should be alive to their possible abuse. On the other hand, they are much more regularly used by analysts, which makes our screen somewhat reliant on them. And often, the gulf between adjusted and reported Ebit isn’t that wide.

Applying the Acquirer’s Multiple to the FTSE All-Share, and pulling out the 30 lowest positive scores, produces a now-familiar batch of value names. The deeply unloved worlds of fund management, domestic oil and gas and engineering are all heavily represented. Can any catch a bid from the market or a bigger fish? We’ll find out in a year’s time.

2024 Takeover Screen Stocks