Business Acquisition Criteria
The business must have a moat – some reason why other businesses would struggle to compete. Moats can come from a variety of sources – MorningStar’s Why Moats Matter offers an overview of moats while Harvard professor Michael Porter’s Competitive Strategy and Columbia professor Bruce Greenwald’s Competition Demystified give more details.
“Having great people” isn’t a moat. Great people are a frequently a necessary condition for a moat but certainly not a sufficient condition. Similarly, a brand name, even a well-known one, is usually not more than the narrowest of moats.
No matter how great your business is, if I can’t understand it, I can’t purchase it. Having a seller stay on for a period post-acquisition – whether as a regular employee or on a consulting business – can help the bridge the gap.
I look for companies with a return on invested capital (ROIC) higher than the median for their industry. Steady higher-than-median ROIC is good; higher-than-median and growing ROIC is better.
To get a rough idea about variation in ROIC across industries, take a look at this McKinsey report.
I’m primarily looking to buy great businesses at a fair price rather than good businesses at a low price. This follows from my long-term holding strategy: since we’re not trying to sell an acquired business after a few years, I’d rather pay more for an excellent business.
Of course, I’m a student of value investing, so there are limits to price. The “intrinsic value” of the business must exceed the price by a “margin of safety” – I arbitrarily use a margin of safety of 25%. This doesn’t necessarily mean that I’ll lowball your other offers by 25% or more in case my estimate of intrinsic value is off. When I calculate intrinsic value, I may find that that value to be higher than whatever the competition has calculated because I see something others don’t.
One last note about intrinsic value: it’s an imprecise art/science and I don’t use academic discounted cash flow analysis (DCF) as taught in business schools. DCF is a theoretically sound framework – the current value of a business is indeed the sum of its future cash flows discounted to the current time – but building a complicated Excel spreadsheet is, in my opinion, a waste of time. One reason is simply that the “terminal value” can drastically skew the results. Worse, typical DCF analysis over-quantifies businesses by implying false precision through numbers… but the DCF inputs are by their nature imprecise themselves. As they say in the field of computer science, “garbage-in, garbage-out.”
Instead of using typical DCF analysis, I look for businesses where the value is obvious. Yes, the financial numbers matter, but I don’t put much weight on financial projections. Rather, I go back to the first criterion – the competitive moat. If a company is understandable, has strong returns on capital, and we’re getting a typical or slightly above price relative to historical owner’s earnings (another estimate I generate; OE isn’t in any standard financial statements) but we’re very confident in the competitive moat, we don’t need to do some fancy DCF.
While I’m open to any business so long as it meets meets the acquisition criteria above, I do have preferences / focus areas. If I stumble upon an interesting business that doesn’t meet these preferences, I’ll still consider it, but usually the thresholds are higher: e.g. a business outside our geographic focus would have to be particularly easy to understand and require less owner involvement post-acquisition because I will be primarily managing the business remotely.
Out of Focus
Since I’m based in South Florida and I’m involved in the day-to-day of our acquired businesses, being close to headquarters is a huge advantage. I also believe South Florida is poised to grow. Miami being major city and the “capital” of Latin America, the warm climate, a lower cost of living relative to northern US metros, the lack of a state income tax, and a generally business-friendly state government all suggest that South Florida’s best days are in the future.
Chicagoland, Greater Boston, and New York City
Although I don’t have the same conviction about future growth as we do with South Florida, I’m confident these three cities will remain major economies. There are other cities I believe will experience higher growth, but I’ve selected these as secondary geographies because I already have close connections with these cities.
My experience is in the USA. I don’t have anything against investments in foreign countries. But I believe that you have to have a deep understanding of a foreign country to invest in a foreign company. I simply don’t have that deep understanding.
Canada, because of it’s geographic proximity, large number of native English speakers (hence why I don’t include Mexico by saying “Non-North America”), and cultural similarity is an unlikely, but potential, option.
Industry/Business Category Focus
Out of Focus
- Light manufacturing
- Information technology
- Real estate
- Financial services
- Business services
- Restaurants & bars
- E-commerce drop-shipping
- Affiliate marketing
- Web design