How to find companies that are actually good at takeovers

Maybe it doesn’t do to be snooty about acquisition-driven companies, those companies whose growth in earnings per share (EPS) relies heavily on dealmaking. Sure, the notion is it’s inferior to the growth that comes from within a company; the internal growth built on the merits and potential of businesses already operating within a group. After all, making acquisitions is a form of betting. Acquired companies bring with them the risk of the barely known, of the factors that slipped past the finance team’s due diligence, of the things that aren’t quite what was advertised in the brochure. So, flip the coin often enough and, before long, there’ll be a loser in the corporate mix, doing harm.

Yet seeing Bunzl (BNZL) deliver another set of satisfactory results last week – for the first half of 2023 – prompted a pause for thought. It’s not that the numbers were that marvellous. The distributor of mundane yet vital low-cost items, such as packaging for the food industry, showed underlying earnings growth of just 3 per cent (and, because of sterling’s mild revival, the figure was actually down when measured at constant exchange rates). Even so, the numbers and the outlook were sufficiently encouraging for chief executive Frank van Zanten to suggest 2023’s underlying operating profit will now match last year’s £886mn. That prompted City analysts to have second thoughts about forecasting a rare dip in earnings. That’s always a brave call since Bunzl has become the epitome of reliability. Only three times in the past 20 years have its earnings shown a dip and its annual growth rate in the past 10 years and five years are remarkably similar (and satisfactory) at 9.5 per cent and 8.4 per cent, respectively.

But, in a way, it shouldn’t be like this. At least, not if the first paragraph holds good because Bunzl is the definitive acquisition-led business. It has acquisitions for breakfast, lunch and tea; altogether 265 of them in the past 30 years, a rate of about one every six weeks.

And its past addiction to acquisitions both led it badly astray and helped embed the idea of the inferiority of growth by deamaking. Back in the 1980s – and at close range – I watched Bunzl buy almost any business that moved (and a good few that didn’t). The going looked good for a few years, and the share price motored. But if a quoted company buys enough dross, sooner or later it will become clear and its outside shareholders will pay the price.

As Table 1 shows, Bunzl’s shareholders eventually paid in a big way. They weren’t the only ones. If Bunzl became badly ill as a result of its bosses’ folly, other acquisition-driven companies suffered a near-death experience; none more so than WPP (WPP), the advertising group being built at breakneck speed by Martin Sorrell in the late 1980s. From peak to trough in the five years 1987-92, WPP’s share price was pretty well wiped out.

In the 1990s, Rentokil Initial (RTO) followed a similar path. Run by Clive ‘Mr 20 per cent’ Thompson, for many years Rentokil did just what Thompson’s moniker said it would – it grew its earnings by 20 per cent. The method was simple – a crude form of ‘bootstrapping’ whereby earnings growth is driven by the simple arithmetic of acquiring new businesses for a lower price/earnings ratio than the multiple on which shares in the acquiring company trade. The trouble is, as Rentokil eventually discovered, earnings rise but the quality of the overall package falls. Buy enough rubbish and eventually even investors will notice. Besides which – and very much in Rentokil’s case – there is the added difficulty that the bigger a group becomes, the bigger subsequent acquisitions must be to make a difference. Eventually, reality caught up with Rentokil and Thompson was fired, although not before he had become Sir Clive.

Maybe what’s most remarkable is that these three groups are still with us, still addicted to their old habit but, apparently, much better at practising it. This oddity prompts the thought: is it possible to quantify the difference in performance between acquisition-reliant companies and those that major on internal development for their progression?

Hence the chart. From a sample based on the components of the FTSE 350 index, the chart takes the five-year average ratio of spending on acquisitions to capital spending, which is a measure of internal development. Then it juxtaposes that with each company’s latest five-year growth rate in free cash flow per share, which is acknowledged as an important measure of a company’s success.

For example, the data point for Bunzl is highlighted on the far right of the chart. It says that average spending on acquisitions in the past five years is 752 per cent of its capital spending and that the latest five-year annual growth rate in free cash flow per share is almost 21 per cent. After eliminating lots of index components for various reasons, the sample was whittled down to 139 companies, which is still enough to produce interesting findings.

If, on average, rising expenditure on acquisitions relative to capital spending correlates with superior growth in per-share cash flow, then the trend line would slope upwards. If the opposite were the case, it would slope downwards. What do we get? A line that’s almost horizontal, sloping neither upwards nor downwards (actually, as the regression equation on the chart shows, the line slopes very slightly down). Not just that but the chart’s dots are scattered so randomly around the trend line that the line isn’t really a trend at all. Put more bluntly, the relationship between spending on acquisitions and on capital spending has zero effect on a company’s ability to grow its free cash flow.

Sure, it’s possible – and even reasonable – to question the terms of this little exercise. The chosen variables seem acceptable and using the five-year average of acquisition spending to capex seems a fair way of quantifying the importance of acquisitions to a group’s growth plan. But it might be suspect to base the success of generating free cash flow on the geometric mean between rather arbitrary start and end dates. This was used for reasons of brevity, but is dependent on one or both of two volatile numbers. A composite number averaging the annual progression and taking account of down years might do a better job. Whether it would reach a substantially different conclusion is another matter.

Besides, what comes across from Table 2 is that some companies appear to be serial winners from playing the acquisition game. The companies are listed by their current share price in relation to the five-year high. So, obviously, those that are currently popular – and whose shares are highest rated – congregate at the top. One or two comparative losers are deliberately included, but, for the most part, the list comprises companies whose returns indicate that growth via acquisitions can both be a pathway to success, and one that’s recognised by investors.

Rather predictably, nothing much in the list appeals to the Bearbull Income Portfolio, although this exercise was never intended to seek out high-yield stocks. That said, motor distributor Inchcape (INCH) and WPP each have an acceptable yield, but sit in the wrong spot of the economic cycle. Still – as ever – let’s take the positives. This week’s trawl through the data should help to shake off any lingering prejudice that there is something intrinsically wrong with companies whose bosses make acquisitions their growth strategy.

bearbull@ft.com