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Is Warren Buffett Crazy?

04/04/2013


On June 28, 2012 Petronas offered to buy Progress Energy (PRQ) for $20.45 per share, a 77% premium to the previous day’s trading price of $11.55. Later, this offer price was increased to $22.00, a total premium of 90.5% to the open market trading price on June 27, 2012.

One month later, on July 19, 2012, Nexen (NXY) closed at $17.08. The next day, CNOCC Limited offered to pay $27.50, a 61% premium.

Why would Petronas or CNOCC pay more than what the company is worth? Haven’t they heard about value investing, which are the principles of the world’s most successful investor, the ‘Oracle of Omaha’, Mr. Warren Buffett?

But wait, let’s have a quick look at what Berkshire Hathaway has paid for its acquisitions of publicly traded companies:


Target

Price Paid (Billions)

Transaction Close Date

Takeover Premium (Billions)

Takeover Premium (%)

H.J. Heinz Company

$28

Pending

$4.6

19.9%

Lubrizol Corp.

$9

September 16, 2011

$2.0

28%

Burlington Northern Santa Fe, LLC

$39.5

February 12, 2010

$9.5

31.5%

MidAmerican Energy Holdings

$14

March 14, 2000

$3.1

28.6%

General Re Corporation

$26.1

December 21, 1998

$4.9

23.4%


Call me crazy, but I would suggest that Mr. Buffett is not. Rather, there is something else going on here; something that must explain this seemingly irrational behaviour.

All Shares are not Valued Equally

If you’ve read this previous posting on The Minority Discount (also called a Discount for Lack of Control, or “DLOC”) you’re aware that a non-controlling interest in a company is attributed a lesser value per share than that associated with a controlling interest.

Now consider this: all publicly traded stock markets are markets of minority interests, and this means that the stock price may not be a true indication of value. I know this goes against the efficient market hypothesis, but consider that when you and I buy shares of a publicly traded company, we’re buying a fraction of an interest in the company. Generally, a very small fraction. Our individual ownership interests have little to no influence on the day-to-day operations of the companies we own, let alone their strategic direction. Short of deciding when to sell, we don’t have the ability to impact the nature and timing of the return on our investment. Rather, for most of us the sum total of our involvement in corporate governance is selecting which member of the board to assign our proxy, and many of us fail to do even that. As such, the value of our investment suffers the impact of the DLOC, and this is reflected in the stock price that’s determined daily on the public markets.

Warren Buffett doesn’t purchase a small fraction of a company; he’s buying the whole thing. The magnitude of his investment provides him seats on the board of directors, direct influence with management and other such benefits.

As an example, think about the significant influence that Mr. Bill Ackman, head of Pershing Square Capital Management LP, had on Canadian Pacific Railway Ltd. (CP) in May 2012. He was able to get the CEO ousted, handpicked the successor, and five members of the board either resigned or agreed not to seek re-election. Months later, half of the board members were nominated by Pershing. Mr. Ackman obtained this influence, perhaps control, essentially by winning a very public proxy battle, even though he directly owned only 14.2% of CP.

Here’s the point. A controlling investment does not suffer the impact of the minority discount. One more share of a target company is worth more to these mega-investors than it is to you or me, and they are willing to pay for that (or some of it) when they make an offer to buy the shares that you and I currently hold.

Chartered Business Valuators often refer to this as the takeover premium, and it is determined as the amount by which the purchase offer exceeds the pre-offer price, divided by the pre-offer price. If this sounds similar to the minority discount, that’s because it is; the relationship between the takeover premium and the minority discount can be expressed as follows:

Takeover Premium = [1 / (1 - Minority Discount)] - 1

Now, let’s apply this formula to the examples above:


Target

Buyer

Takeover Premium

Minority Discount

Nexen Inc.

CNOOC Limited

61%

37.9%

Progress Energy Resources Corp.

Petronas

90.5%

47.5%

H.J. Heinz Company

Berkshire Hathaway / 3G

19.9%

16.6%

Lubrizol Corp.

Berkshire Hathaway

28.0%

21.9%

Burlington Northern Santa Fe, LLC

Berkshire Hathaway

31.5%

23.9%

MidAmerican Energy Holdings

Berkshire Hathaway

28.6%

22.3%

General Re Corporation

Berkshire Hathaway

23.4%

18.9%


So, I would suggest that you sold your Nexen or Progress Energy shares for a fair price. However, it is key to recognize that ‘fair’ is determined from the point of view of the buyer; in these cases that person is a ‘soon to be’ controlling shareholder. I would also suggest that you bought the share for a fair price from your point of view—that of a non-controlling shareholder. Finally, it explains the prices Mr. Buffett is willing to pay.


The Impact on Private Enterprises

As with many theoretical explanations of real-world observations, there is considerable research and discussion on this topic. Some of that evidence confirms the above, and some provides alternative explanations. In order to introduce these concepts in a format such as this, they have been greatly simplified, perhaps overly so. In fact, there are many additional factors that would impact the quantum of the DLOC, and by inference, the takeover premium. These factors change over time and in different industries, and are different in each specific instance.

These are complex issues, and should be discussed in detail with your professional advisors. This is especially true when considering what impact, if any, they may have on the value, or perceived value, of a non-controlling interest in a privately held enterprise.  There are tools available to influence this impact. If you are considering allowing key employees to acquire an equity position in your company, or perhaps facilitating the exit of a shareholder, please contact your MNP Advisor and we will be happy to see how these concepts apply to your specific situation.