Tag Archives: Pay Off

Is A Company You Own Making A Dumb Acquisition

As a shareholder, you do well to place more emphasis on risk than on reward. Corporate management usually does the opposite, and this is why most large acquisitions fail.

In fact, I assume from the start that an acquisition will fail — or at least will turn out not nearly as profitable as the picture management paints.

For starters, a buyer typically pays too much. An old Wall Street adage comes to mind:

“Price is what you pay; value is what you get.”

It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the latest trade. When a company is acquired, though, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.

How much higher? Acquisitions have the elements of a zero-sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince the company’ s board and its shareholders that the sale price is high (unfairly good). The buyer in turn needs to convince his constituents that they are getting a bargain. Remember, both are talking about the same asset.

This is where a magic word — which must have been invented by Wall Street banks’ research labs — comes into play: “synergy.” The only way this acquisitions dance can work is if the buyer convinces his constituents that combining the two companies will create additional revenues otherwise not available, and/or it will eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.

If you examine why General Electric Co., for example, has been a subpar investment over the last two decades, you’ll find that it’s because of poor capital allocation. The company lost a lot of value in making destructive acquisitions — buying businesses at high prices, relying on false or unfulfilled synergies, and selling (divesting) at reasonable (or low) prices.

There are also a lot of “dis-synergies” (a term you’ll never see in an acquisition press release). The two corporate cultures may simply be incompatible. One company may have a strong founder-led culture, while in the other company decisions are made by consensus. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.

A case in point: Silicon Valley pioneer HP Inc. has been substantially gutted by large acquisitions. When the company acquired Compaq in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. The same happened with EDS (acquired in 2008), which had a service culture, and again with Autonomy (in 2011) — a software company that ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.

Acquisitions can also lead to an employee morale problem. The day before the acquisition, people at the acquired company came to work as usual. They were not particularly worried about the future. After the acquisition announcement, though, their job security is perceived as being at risk, and they are now on LinkedIn updating their profiles and networking. Now they worry about the sustainability of their paychecks (and finding new jobs) a lot more than how they can help this great, new, more profitable organization that may be about to let them go.

Finally, integrating businesses is difficult. Aside from the culture problems, companies must realign global supply chains, move or combine headquarters, and merge software systems. In large companies, this task is like merging two complex nervous systems.

So while the acquisition press releases may tout synergies, they don’t talk about the price tags and dis-synergies (risks) that come with the deal, too.

Here’s a good example of the right approach: Gilead Sciences’s management has a terrific, but small, acquisition record. In 2011, it paid $11 billion for Pharmasset, a company that had no revenues and a molecule a few years out of (maybe) being approved: a cure for hepatitis C. Well, cure hepatitis C it did. It was an incredible success, generating $20 billion in revenues in just the first year of sales. It is incredibly difficult to judge this transaction, though, because we don’t really know the role that luck played here.

Wall Street sees Gilead’s October purchase of Kite Pharma as Pharmasset 2.0. Gilead is paying $11.9 billion for a company that has just $20 million in revenues but also has a possibly revolutionary medicine to treat cancer — and potentially reap billions in profits. We own shares of Gilead and would love to believe that this acquisition will be a success, but we don’t know — and neither does Wall Street.

Yet from a risk perspective, even if the Kite acquisition doesn’t work out, it will not weaken Gilead. It will the cost the company one year of earnings. Gilead generates significant, stable cash flow, has a great balance sheet and management that is great at running the business, and is a rational, patient capital allocator. Indeed, our upbeat view on the company has not really changed, except that now we also hold a $12 billion lottery ticket that may cure cancer. Moreover, this acquisition doesn’t have most of the dis-synergy risks we discussed above — Gilead is buying research and scientists. Science and luck will decide whether the deal is successful. If Kite’s drug is as good as Gilead’s management thinks it is, then we’ll have Pharmasset 2.0. If not, we lost a year of earnings.

To be sure, acquisitions can create value. But when a company grows through acquisitions, its management needs to have a highly specialized skill set that is often different from that used in running a company’s day-to-day operations.

Accordingly, it’s important to examine the motivations of management when it makes an acquisition. When management feels that their business, on its own, is threatened by future developments, their acquisitions will have a “Hail Mary” desperation to them — and a corresponding price tag.

Bitcoin – Millennial’s “Fake Gold”

I’ve been asked about Bitcoin a lot lately. I’ haven’t written anything about it because I find myself in an uncomfortable place in agreeing with the mainstream media: It’s a bubble. Bitcoin started out as what I’d call “millennial gold” – the young (digital) generation looked at it as their gold substitute.

Bitcoin is really two things: a blockchain technology and a (perceived) currency. The blockchain element of Bitcoin may have enormous future applications: It may be used for electronic contracts, voting, money transfers – and the list goes on. But there is a very important misconception about Bitcoin: Ownership of Bitcoin doesn’t give you ownership of the technology. I, without owning a single bitcoin, own as much Bitcoin technology as someone who owns a million bitcoins; that is, exactly none. It’s just like when you have $1,000 on a Visa debit card: That $1,000 doesn’t give you part ownership of the Visa network unless you actually own some Visa’ stock.

Owning Bitcoin gives you a right to … what, actually? Digital bits?

I can understand gold bugs and the original Bitcoin aficionados. The global economy is living beyond its means and financing its lifestyle by issuing a lot of debt. Normally this behavior would cause higher interest rates and inflation. But not when you have central banks. Our local central bankers simply bought this newly issued debt and brought global interest rates down to near-zero levels (and in many cases to what would have been previously unthinkable negative levels). If you think investing today is difficult, being a parent is even more difficult. I tried to explain the above to my sixteen-year-old son, Jonah. I saw the same puzzled look in his eyes as when he found out where babies come from. I also felt embarrassed, for my inability to explain how governments can buy the debt they just issued. The concept of negative interest rates goes against every logical fiber in my body and is as confusing to this forty-four-year-old parent as it is to my sixteen-year-old.

The logical inconsistencies and internal sickness of the global economy have manifested themselves into a digital creature: Bitcoin. The core argument for Bitcoin is not much different from the argument for gold: Central banks cannot print it. However, the shininess of gold has less appeal to millennials than Bitcoin does. They are not into jewelry as much as previous generations; they don’t wear watches (unless they track your heartbeat and steps). Unlike with gold, where transporting a million dollars requires an armored track and a few body builders, a nearly weightless thumb drive will store a dollar or a billion dollars of Bitcoin. Gold bugs would of course argue that gold has a tradition that goes back centuries. To which digital millennials would probably say, gold is analog and Bitcoin is digital. And they’d add, in today’s world the past is not a predictor of the future – Sears was around for 125 years and now it is almost dead.

A client jokingly told me that his biggest gripe with me in 2016 and 2017 was that I didn’t buy him any Bitcoin. I told him not so jokingly that if I bought him Bitcoin, he’d be right to fire me. Maybe I’m a dinosaur; but, like gold, Bitcoin is impossible to value. What is it worth? It has no cash flows. Is a coin worth $2, $200, or $20,000? But Wall Street strategists have already figured out how to model and value this creature. Their models sound like this:

“If only X percent of the global population buys Y amount of Bitcoin, then due to its scarcity it will be worth Z”.

On the surface, these types of models bring apparent rationality and an almost businesslike valuation to an asset that has no inherent value. You can let your imagination run wild with X’s and Y’s, but the simple truth is this: Bitcoin is un-valuable.

In 1997, when Coke’s valuation started to rival some dotcoms, bulls used this math:

“The average consumer of Coke in developed markets drinks 296 ounces of Coke a year. These markets represent only 20% of the global population.”

And then the punchline:

“Can you imagine what Coke’s sales would be if only X% of the rest of the world consumed 296 ounces of Coke a year?”

Somehow, the rest of the world still doesn’t consume 296 ounce of Coke. Twenty years later, Coke’s stock price is not far from where it was then – but on the way it declined 60% and stayed there for a decade. Coke, however, was a real company with a real product, real sales, a real brand and real tangible, dividend-producing cash flows.

If you cannot value an asset you cannot be rational. With Bitcoin at $11,000 today, it is crystal clear to me, with the benefit of hindsight, that I should have bought Bitcoin at 28 cents. But you only get hindsight in hindsight. Let’s mentally (only mentally) buy Bitcoin today at $11,000. If it goes up 5% a day like a clock and gets to $110,000 – you don’t need rationality. Just buy and gloat. But what do you do if the price goes down to $8,000? You’ll probably say, “No big deal, I believe in cryptocurrencies.” What if it then goes to $5,500? Half of your hard-earned money is gone. Do you buy more? Trust me, at that point in time the celebratory articles you are reading today will have vanished. The awesome stories of a plumber becoming an overnight millionaire with the help of Bitcoin will not be gracing the social media. The moral support – which is really peer pressure – that drives you to own Bitcoin will be gone, too.

Then you’ll be reading stories about other suckers like you who bought it at what – in hindsight – turned out to be the all-time high and who got sucked into the potential for future riches. And then Bitcoin will tumble to $2,000 and then to $100. Since you have no idea what this crypto thing is worth, there is no center of gravity to guide you or anyone else to make rational decisions. With Coke or another real business that generates actual cash flows, we can at least have an intelligent conversation about what the company is worth. We can’t have one with Bitcoin. The X times Y = Z math will be reapplied by Wall Street as it moves on to something else.

People who are buying Bitcoin today are doing it for one simple reason: FOMO – fear of missing out. Yes, this behavior is so predominant in our society that we even have an acronym for it. Bitcoin is priced today at $11,000 because the fool who bought it for $11,000 is hoping that there is another, greater fool who will pay $12,000 for it tomorrow. This game of greater fools is not new. The Dutch played it with tulips in the 1600s– it did not end well. Americans took the game to a new level with dotcoms in the late 1990s – that round ended in tears, too. And now millennials and millennial-wannabes are playing it with Bitcoin and few hundred other competing cryptocurrencies.

The counterargument to everything I have said so far is that those dollar bills you have in your wallet or that digitally reside in your bank account are as fictional as Bitcoin. True. Currencies, like most things in our lives, are stories that we all have (mostly) unconsciously bought into. (I highly encourage you to read my favorite book of 2015: Sapiens, by Yuval Harari.) Of course, society and, even more importantly, governments have agreed that these fiat currencies are going to be the means of exchange. Also, taxation by the government turns the dollar bill “story” into a very physical reality: If you don’t pay taxes in dollars, you go to jail. (The US government will not accept Bitcoins, gold, chunks of granite, or even British pounds).

And finally, governments tend to look at Bitcoin and other cryptocurrencies as a threat to their existence. First, governments are very particular about their monopolistic right to control and print currencies – this is how they can overpromise and underdeliver. No less important, the anonymity of cryptocurrencies makes them a heaven for tax avoiders – governments don’t like that. The Chinese government outlawed cryptocurrencies in September 2017. Western governments are most likely not far behind. If you think outlawing a competitor can happen only in a dictatorial regime like China’s, think again. This can and did happen in a democracy like the US. With Executive Order 6102 in 1933, US President Franklin D. Roosevelt made it illegal for the US population to “hoard gold coin, gold bullion, or gold certificates.”

However, nothing I have written above will matter until it does. Bitcoin may go up to $110,000 by the end of the 2018 before it comes down to … earth. That is how bubbles work. Just because I called it a bubble doesn’t mean it will automatically pop.

Why You Are Like The Astros

You’re the Astros, not the Dodgers, Yankees or Red Sox

The city of Houston is elated, tired and relieved today with the close of an epic World Series and our team coming out on top. This has been a long time coming, 56 years to be exact and it almost feels surreal. Houston is a tough city, not in the way of these streets are tough-though some are. More in a way that we’re resilient, diverse and have that never say never attitude. Yes, baseball is just a game, but this year it’s provided some much needed reprieve from daily life in a region devastated from Hurricane Harvey.

Look back a couple of years and this is a team that endured 3 consecutive 100 loss seasons. A starting over, if you will from being a once competitive staple in the National League Central Division. This organization has had to pick itself up from bouncing around on rock bottom. They could have easily tried to spend their way out of the hole or they could very strategically and patiently draft and develop talent little by little, year by year. This is a roster that until recently was void of any top earners and really the last bet Jeff Lunhow the Astros general manager made was one of risk/reward in Justin Verlander and boy did that pay off in ways only imaginable for the Astros fans. This team is now set up for years to come, by not taking the easy way out, by sticking to their plan and enduring the process knowing that these days will come. Is this a Dynasty? Only time will tell, but they are set up for the next several years with players under contract and a clubhouse that appears to love each other’s company.

The Dodgers, Yankee’s and Red Sox have the highest payrolls in baseball and have a collective 40 World Series Championships. In retrospect, they are your too big to fail banks. You and I we’re just mere mortals. Championships were bought and paid for long ago for times just like this week. They can afford to swing and miss because they’ll just step back up in the batter’s box with more money to offer and the promise of chasing a ring to superstar free agents. Most people, companies or teams don’t have that luxury.

In a lot of ways, we’re just like this Astros team, our financial wealth generally didn’t appear from thin air. Rather it was worked on, sacrifices and plans were made. There are times life throws us curve balls in the form of sickness, job loss, natural disaster, children, death or just unexpected expenses. This is when one must remember to stay the course, market returns help grow your money, but you and your good saving and spending habits will get you to your destination.  Risk management is now key, especially when you accumulate assets or when you reach your goal. For most, that goal is retirement. Find a Jeff Lunhow or in our case an advisor to help chart your course, you see you don’t have to be the Dodgers, Yankees or Red Sox to get the prize.

The road isn’t straight nor is it easy, but just like these Astros showed a little planning, nurturing, patience, sound defense and a double or home run every now and then can get you a long way.

Should You Pay Off Your House? 7-Things To Consider

“If I have the cash should I pay my mortgage off early?”

That is a regular question we are asked.

While it might seem to be the simple answer of “yes,” such is not always the case. Like anything, when it comes to making decisions for an individual, or family, a plan and some sound advice is always beneficial when facing these tough decisions.

Since we can’t do a plan, here’s some advice.

Everyone’s scenario is different and I do mean everyone. You may be able to pay your mortgage off and still have millions in the bank. Maybe you have enough guaranteed income and additional savings that paying the house off earlier won’t cause you to skip a beat. Or maybe you need all additional liquidity, flexibility and income you can get.

Regardless of your scenario, I believe everyone can take something from these 7 considerations.

Let’s set the record straight. I’m not opposed to paying your home off early when given the right scenario. In fact, there are times that paying your home off early can provide great peace of mind. First, I would go through this exercise:

1) Have a sounding board- No, not your neighbor

This should be your advisor, CPA and/or attorney. If you were my client, I’d prefer it be me. We’d build a team of professionals or work with your existing accountants and attorneys. Your team should be constructed of a group of individuals that have your best interest at heart, a fiduciary is a good start.

The only reason it shouldn’t be your neighbor is they generally have a biased opinion based on what they did. For every one good piece of advice I’ve heard a client gleam from a neighbor there are 9 bad ones.

I’m sure your neighbor is a great guy, extremely smart and successful, but odds are they don’t know your full financial situation. It’s not that your neighbor isn’t smart or even that it’s bad advice, it’s just that it’s not good advice for you.

Gathering information from a number of people may be helpful for you to digest the magnitude of such a decision.  Remember to take that advice with a grain of salt and don’t get paralysis by analysis. Sometimes too many differing opinions can cause us to shut down or put decisions on the back burner.

Unfortunately, there are times we find out clients have paid their home off early after the fact.

For most, paying your home off early is more of an emotional decision than a planning decision. We need to reverse this aspect, just like when investing in markets we need to be as my partner Lance Roberts says “void of emotion.”

This is why it’s important to have someone on the outside looking in. Someone who has seen the triumphs, trials and tribulations of others, experiences that are sometimes priceless and can evaluate your scenario holistically.

2) How long do you plan to live in your home?

The amount of time you plan on living in your home could alter the decision to put your mortgage to bed.

Less than 5 years?

Keep your hard-earned cash on hand. Housing markets, like stock markets move in cycles. I’d hate to have to move and not have the necessary liquidity to put down on a new home or have to sell in a down or slow market.

5-15 years?

Maybe you pay it off? I end that last sentence with a question mark, because this time frame is a bit trickier.

If you find yourself in position to pay your home off early I would hope you could weather any recessionary period even after making that last home payment.

You must have enough in emergency funds and not pull from other assets that are designated to other goals. If you lost your job tomorrow could you still pay your bills and for how long?

This now becomes a best use of capital question. How much interest are you paying and how much can you earn in a relatively safe investment. In today’s environment taking advantage of lower borrowing rates doesn’t seem like such a bad idea.

This is your “forever home.”

Meaning you plan to stay there until you can no longer care for yourself. I really have a hard time with changing your liquid asset (cash) and turning it into a hard asset (your home.) As my partner, Richard Rosso calls it “turning water into ice” I think the analogy fits considering you’re taking your hard-earned cash and putting it into something that’s difficult to “chip” away at. Rule 6 can also play a role in this decision, sometimes when you need senior care you don’t have the luxury of funding it once your home sells.

There is always an exception to the rule, in this instance it’s if the money is going to burn a hole in your pocket. Pay it off, lower your expenses and at least you will have put the cash into something worthwhile, your home.

3) Tax Deductibility

Itemize your taxes? If you itemize many consider the interest tax deduction as the “end all be all” when considering paying off your home. The truth is the majority of people that are paying off their homes typically are in the last years of payments and have little interest to write off.

When considering the deduction of interest one must remember that it’s not 1 for 1. What do I mean by that? The deduction doesn’t reduce your tax burden 1 for 1, it reduces your adjusted gross income by the amount of deductible interest or overall deductions.

For example,

Your Adjusted Gross Income (AGI) is:      $100,000

Itemized Deductions are:    $15,000

Taxable Income:   $85,000

Yes, it does reduce your taxes. No, it’s not the reduction most think.

4) Best use of funds

What are the best use of funds? With current interest rates still near all-time lows, it would suit most to borrow money and use your cash in another way to get more bang for your buck. For most people leverage and credit is not your friend, however when used properly it’s a great tool.

Can you make more on your money investing semi conservatively? For instance, we can currently find investment grade bonds with a coupon of 5% with a 5-7 year duration, buying them at a bit of a premium you may see a 3-4% YTM return on your money.

The other argument is if you do pay your home off early and you’re in retirement the amount needed for expenses will decrease which will in turn decrease the amount you will need to pull from your investment accounts to live.

If you’re in the accumulation (working) mode paying off the home early would increase the amount you could put aside monthly.

Enter, the 5th consideration, liquidity.

5) Liquidity=Flexibility=Options

How much is liquidity worth to you? Having liquidity gives you options.

It’s likely you don’t fall into this category since you’re still reading and considering options. Congrats, you’re in an enviable situation to the majority of your peers. The liquidity you possess is powerful.

According to a Bankrate study 69% of Americans don’t have enough saved to meet 6 months of expenses.

When disaster strikes or opportunity knocks I don’t know about you, but I want cash in hand or liquid assets.

Natural disaster, take Hurricane Harvey and all the Houstonians (roughly 70-80%) without flood insurance.  There are some very tough decisions to be made by many, but in the end cash is certainly king.

Business opportunity or real estate deal you can’t pass up?

Need to move quickly, medical or family emergency or would just like to generate additional cash flow?

Cash flow is an important part of the equation. Can these funds generate some type of income for you and your family and you still retain a degree of flexibility? Go back to #4, best use of funds.

6) Do you have Disability or LTC Insurance?

While in your working years disability insurance is a must. If you use a substantial portion of your liquid assets to pay your home off it could be even more important.

How will you maintain the lifestyle your family is accustomed to if something were to happen such as a car accident or a health scare that kept you or your spouse from working for an extended period of time? A large part of financial planning is the risk management of protecting your family. Make sure you’re protecting your most precious asset.

Long term care insurance, do you, have it? Can you get it? Can you afford it without disrupting your cash flow? Do you need it? I could write a whole article on just these topics, but this should certainly be a consideration when paying off your home.

Remember, in your retirement years getting access to funds can be extremely important and when the funds are tied up in a home, access is limited and can take time.

If you do pay your home off early in retirement, having a home equity line of credit ready and available to use may mitigate some of that risk. I would also recommend having a Power of Attorney who can help in the event you’re incapacitated.

7) But my house has gone up so much in value!

For starters, if you have been in your home for any period of time I’d hope that to be the case. You’ve been socking money away in the form of your monthly payment year after year now add a little inflationary growth and I think you get my point.

But…

Have you ever stopped to calculate how much you’ve actually put into your home in maintenance and improvements? And don’t forget to add those pesky property taxes and HOA fee’s.

Most find that after a similar exercise they come to realize that maybe their home isn’t the investment they thought it was.

The following two charts show prices in real terms and the percentage change.

Price in real terms indicate prices in $’000 at 2015 prices (deflated by CPI) and the percentage change shows the change in inflation adjusted prices between the two selected dates of 1980 to Q2 of 2016

These charts indicate that if you weren’t living in New York, San Francisco, Los Angeles, Miami, Boston or a handful of other offshoots the average American or Houstonian for that matter didn’t see substantial or real growth in their home valuations.

Unless you’re finding a home in foreclosure, at a heck of a discount or buying in one of the above valley’s I suspect that if we were as diligent about funding our other goals we may have a different outlook on what’s really our best investment.

Another consideration if you’re truly treating your home like an investment is you must actually sell it to realize any so called gains, after all you will always need someplace to live.

In conclusion:

Paying off your home early is a very personal decision. It’s a decision that’s best evaluated if you can take a step back and look at the big picture. Personally, I don’t like much debt, but debt can be a powerful tool when used correctly or a disastrous enabler.

There are so many sides to this coin, I feel like I could write for days, analyze every scenario and consideration, but then we’d have a book. This is only meant to be a template or guide for things to consider should you find yourself in this scenario.

Consider your circumstances, plan accordingly and make the right decision.  Find or use your resources to make decisions you feel confident in and don’t look back. Learn from your mistakes, don’t dwell on them.

There is no one size fits all.