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The risk of being acquired at a much lower price than your entry


plato1976
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This risk is stopping me from allocating a significant part of my portfolio into some small cap names;

the question is how to evaluate such risk

 

For mega cap like apple or BAC it's unlikely to happen, and I feel comfortable to invest a big portion of my money into them (20% or 30% or even more) when I think the timing and valuation is right.

 

But a small cap (100M to 1B), even if your entry is significantly below the intrinsic value, someone can still acquire it way below your entry and make your investment a permanent loss. I am not even talking about RIMM or DELL which are not that small... Maybe you can look into management holding ratio but then there is a possibility of LBO (esp when the corp is cash rich).

 

Any suggestion how to evaluate such risk ?

 

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The first thing that comes to mind is how much skin management has in the game. If they don't own much stock, acquirers can dangle shiny things in front of them to convince them to support a sale.

 

If they own a ton of stock, suddenly a lowball offer doesn't seem so attractive anymore...

 

I'm no expert by any means, but this is what I would look at first.

 

 

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The first thing that comes to mind is how much skin management has in the game. If they don't own much stock, acquirers can dangle shiny things in front of them to convince them to support a sale.

 

If they own a ton of stock, suddenly a lowball offer doesn't seem so attractive anymore...

 

I'm no expert by any means, but this is what I would look at first.

 

The problem is when the owners are the one buying out everyone else..

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Then there's management leveraged buy-out

Say management holds 30% which is a significant stake, but if they are motivated to buy the remaining 70% at low price ...

 

I see these kind of things as a big risk for our small minor shareholders

 

The first thing that comes to mind is how much skin management has in the game. If they don't own much stock, acquirers can dangle shiny things in front of them to convince them to support a sale.

 

If they own a ton of stock, suddenly a lowball offer doesn't seem so attractive anymore...

 

I'm no expert by any means, but this is what I would look at first.

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The first thing that comes to mind is how much skin management has in the game. If they don't own much stock, acquirers can dangle shiny things in front of them to convince them to support a sale.

 

If they own a ton of stock, suddenly a lowball offer doesn't seem so attractive anymore...

 

I'm no expert by any means, but this is what I would look at first.

 

The problem is when the owners are the one buying out everyone else..

 

Right, I think my brain skipped that last part about holding ratio...

 

Not sure how to mitigate management lowballing you, except maybe to look at historical undervaluation; has it been very cheap in the past? If they didn't pull the trigger then, it might be an indication that they won't in the future and prefer staying public, though certainly not a guarantee...

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Guest longinvestor

The first thing that comes to mind is how much skin management has in the game. If they don't own much stock, acquirers can dangle shiny things in front of them to convince them to support a sale.

 

If they own a ton of stock, suddenly a lowball offer doesn't seem so attractive anymore...

 

I'm no expert by any means, but this is what I would look at first.

 

The problem is when the owners are the one buying out everyone else..

 

This is exactly why Berkshire is unique. The owner's manual (and their behavior) clearly puts your ownership interest at the same level as all other owners. You are the owner. Period. Berkshire may do very well or poorly in the future but the one thing you don't worry about is getting "bought out". As long as this culture is maintained, Berkshire will do fine for investors (owners), even past Warren's tenure.

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When the whole sector is undervalued the situation is not that bad, if one extremely undervalued corp is acquired below intrinsic value (but still above the market price), you can take the money and switch to another corp in the same sector (hopefully similarly undervalued, or at least at a similar valuation as the buy-out price b/c buy-out will use sector valuation as a reference, usually). The situation is esp bad when your corp is really unique...

 

Anyway, that's why I think we should give berkshire or maybe fairfax some premium :)

 

The first thing that comes to mind is how much skin management has in the game. If they don't own much stock, acquirers can dangle shiny things in front of them to convince them to support a sale.

 

If they own a ton of stock, suddenly a lowball offer doesn't seem so attractive anymore...

 

I'm no expert by any means, but this is what I would look at first.

 

The problem is when the owners are the one buying out everyone else..

 

This is exactly why Berkshire is unique. The owner's manual (and their behavior) clearly puts your ownership interest at the same level as all other owners. You are the owner. Period. Berkshire may do very well or poorly in the future but the one thing you don't worry about is getting "bought out". As long as this culture is maintained, Berkshire will do fine for investors (owners), even past Warren's tenure.

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Seems like that is most likely to happen when there are voting rights and governance issues.  I've seen it happen in Canada though several times.

 

But wondering why that issue is not just a subset of buying a stock and having the price head south instead of north?

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I guess you should just size your position accordingly. Usually though, if the buyout price is absurdly low, some litigants do usually emerge although it may not be wise to assume that it will happen for every situation.

 

To learn more about this, check out the EBIX securities litigation and litigation following the AutoInfo buyout.

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  • 5 months later...

As someone who frequently invests in micro caps this is a real concern for me. Even large insider ownership does not necessarily protect against a "take under". Novus Energy provides a good example of a situation where the management sold the company well under intrinsic value because they were given cushy jobs and large salaries with the acquiring company.

 

WestFire Energy was a great company trading well below intrinsic value when the majority share holder (Sprott Resources) decided to merge it with failing Guide Resources to create Long Run Exploration. Sprott prevented the bankruptcy of Guide Resources, but owners of  West Fire ended up holding a much less desirable company.

 

While insider ownership and majority share holders can provide safety and stability, they can also rob you of your investment if they have ulterior motives. It is a difficult risk to assess.

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The reality is that you can do very little about it. It is part of the package.

The best defence is a bigger position acquired at prices well under current MV, so that you at least get a liquidity event.

 

Example:

500,000 shares bought at an average 8c (40K), trading at a MV of 20c (100K), with an IV of 40c (200K). You could not sell this many shares without materially dropping the market price by 50-60% (11c); leaving a walkaway gain of 3c (15K) before costs. If management made an offer at 10% (low) over market (22c); your walkway gain would be 14c (70K) - 4.67x more.

 

You might not like it, but you will be giving them a kiss.

 

SD

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If management is able to acquire the company at a price much lower than your entry you probably didn't buy it that cheap. It basically never happens that a company isn't acquired at some sort of premium compared to the latest market price. So for management to be able to buy significantly below your entry price it means that the stock needs to drop even more after you bought it. This would usually mean that intrinsic value also dropped significantly after you bought it. It doesn't mean that management might not be able to get a good deal, but the main reason for the loss is the drop in intrinsic value after you bought.

 

If you buy something that should be worth $1/share, but is trading at $0.50/share management might be able to buy it at $0.75/share: giving themselves a good deal. But too be honest; I don't see that as a major problem. Both sides needs to be winners for a successful deal.

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This risk is stopping me from allocating a significant part of my portfolio into some small cap names;

the question is how to evaluate such risk

 

For mega cap like apple or BAC it's unlikely to happen, and I feel comfortable to invest a big portion of my money into them (20% or 30% or even more) when I think the timing and valuation is right.

 

But a small cap (100M to 1B), even if your entry is significantly below the intrinsic value, someone can still acquire it way below your entry and make your investment a permanent loss. I am not even talking about RIMM or DELL which are not that small... Maybe you can look into management holding ratio but then there is a possibility of LBO (esp when the corp is cash rich).

 

Any suggestion how to evaluate such risk ?

 

I'm not sure how you evaluate this risk unless you have some reason to trust the management and/or any large shareholders.  This falls under: don't allocate a significant portion of your portfolio to any one small/microcap stock.

 

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You also need to question why you are in this space at all:

 

To amass 500,000 shares would require 25 trades @ 20,000 shares/each; & another 25 to exit if there is no liquidity event. At 1 trade/day a round trip is 2.5 months, & for that entire time you are hoping the market has not noticed. Lot of execution risk, & a lot of work, for not enough return.

 

You could have taken the 40K of equity & bought a real share on margin. Assume 4000 shares @ $20, paying a $.50 annual dividend, using 40K of margin @ 5.00%. Divs (2K) = Interest (2K) = carry cost of $0. Assume a 20% gain & a sale @ $24; total gain = 4000*(24-20) = 16K. Little execution risk, little work, better quality, more liquidity - & a higher return.

 

Quality matters.

 

SD

 

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Guest deepValue

Geoff Gannon experienced a management-led buyout below intrinsic value.

 

Bancinsurance’s book value was $8.52 a share in March. It’s $9.50 today. $9.50 would’ve been a fair buyout price. The board agreed to $8.50. That cheats shareholders out of 12% in extra returns. It’s not fair. That’s life.

He just had to eat it: http://gannonandhoangoninvesting.com/blog/case-study-geoffs-investment-in-bancinsurance-2-failures-and.html

 

Background: http://www.gurufocus.com/news/108454/case-study-geoff-gannons-investment-in-bancinsurance-bcis--and-his-letter-to-the-board-of-directors

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