Why Buffett Pulled Back: Companies Overvalued after “Purchasing Frenzy” Fueled by “Cheap Debt”

Wolf Richter wolfstreet.com, www.amazon.com/author/wolfrichter

And why his “recent drought of acquisitions” is likely to continue.

Warren Buffett explains in his annual letter to Berkshire Hathaway shareholders why he made only one large deal in 2017 (the 38.6% stake in Pilot Flying J) though his investment vehicle is sitting on a huge pile of cash, and why it will continue to sit on this pile of cash, rather than invest it. This “recent drought of acquisitions,” as he says, came down to this: Companies are overvalued.
He blames the “purchasing frenzy” by deal-crazy CEOs, “cheap debt,” and other factors, including those CEOs’ promises of “synergies” that then rarely or never materialize.
Buffett goes through it step by step. One of the four “key qualities” for acquiring stand-alone businesses is a “sensible purchase price,” he said:

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.

“Why the purchasing frenzy?” Buffett asks and then shows how that frenzy happens:

• “In part, it’s because the CEO job self-selects for “can-do” types.”
• “Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase.”
• “Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size.”
• “Investment bankers, smelling huge fees, will be applauding as well.”
• “If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.”

Then there’s the central-bank aspect – the effects of their experimental emergency monetary policies that have now endured for nine years. In the corporate credit market, these policies have pushed the cost of borrowing, even for risky companies doing highly leveraged deals, to ludicrously low levels:

The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed.
At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities).
We also never factor in, nor do we often find, synergies.

Then there’s the issue of leverage. When money is cheap, companies lever up. As bankers used to say: Bad deals are made in good times – though bankers no longer say that. In tough times, money is expensive, liquidity is scarce, CEOs are prudent, and bad deals are hard to pull off because the bad deals that had been made in good times are now disintegrating into a costly mess before their very eyes.
But Buffett is not big into leverage, and it shows in the returns, he says:

Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need.

This is not to say that Buffett might not make another “very large” acquisition “from time to time” if an opportunity arises. “In the meantime,” he says, “we will stick with our simple guideline: The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”
This statement about “prudence” – and the reasoning behind it – is sort of a warning about the risk-taking prevalent in the markets these days, and the distortions and overvaluations it’s causing, and the fact that this frenzy won’t last forever, and that there will be many buying opportunities after this frenzy has unwound.
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