A Trade vs An Investment
Big Deal Small Business: A Trade vs An Investment
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In Tuesday’s post, I talked about returns skew and confirming that the deal has enough upside skew to offset the massive downside risk inherent in every SMB deal.
Today, I get at that same concept but from a different angle. Today is about trading versus investing.
Upfront caveat: there’s a ton of literature & tweet threads on different investing styles, trading vs investing, value vs growth, etc.
This short post is just a simple framework I use when I analyze a potential acquisition — it’s not a definitive investing philosophy or codified set of terms. That said, it clearly derives from value investing, which is how I’ve been trained as an investor.
A Trade
At its core, I view a trade as buying at a discount to intrinsic value. For example, you think a business is worth $100, you find an off-market deal where you can buy it for $80.
The idea is that the market is not recognizing the true value of the asset right now, and therefore you can make money by realizing its true value. The underlying assumption is that over time, the market will realize its true value, and you’ll be able to sell it at full value for a profit.
In SMB, this usually means extremely low multiple deals (like 2x), which can imply the market thinks the business has a high risk of falling apart in a couple years after the owner leaves.
When you buy that business for 2x, you’re taking the bet that you think it’s not quite that risky, so should be worth at least 3x.
If you can operate it successfully for 3-5 years and prove that out, the market should recognize that the business is quite enduring, and the exit multiple will reflect that.
In that deal, you made your money by proving that intrinsic value is higher than the market thinks it is today.
An Investment
An investment can have elements of a trade (buying at a discount to intrinsic value). But when I make an investment, I have a thesis that the intrinsic value itself will increase over time.
Let’s say a business today might be worth $100 based on 5x $20 of cash flow, which translates to a 20% cash flow yield.
That multiple or cash flow yield incorporates two key elements:
The growth profile of the business
The riskiness of the business
For example, a recurring revenue business is lower risk (lower odds that cash flow go away), so the required cash flow yield to own that business is lower than a non-recurring revenue business.
Similarly, a fast-growing business should trade at a higher multiple (lower cash flow yield) than a slow-growing business. You’ll make up for that lower cash flow yield with growth in cash flow over time.
So let’s say the market is exactly correct — the business based on its current riskiness and growth profile is worth 5x, or 20% cash flow yield.
However, I might have a thesis on:
Ways I can change the business model to make it more recurring in nature
Ways I can accelerate the company’s growth profile
Ways in which the industry is undergoing changes that will benefit this business
Ways I can reduce costs to change the company’s margin profile
If I can execute on these ideas, I can improve the growth profile and lower the riskiness of the business, which should eventually translate into a higher exit multiple.
In this way, I have increased the intrinsic value of the business.
A Trade vs An Investment
A trade can be a great move for an investment firm that is in the business of deploying capital and making money.
But in SMB acquisitions, you’re investing your time & effort into the deal. As a result, I think the deal should also be an investment, not just a trade.
It’s tempting to look at a company trading for 2.5x and just say “wow, if I can hold this thing flat for 5 years, I’ll make a ton of money by just clipping cash flow.”
That’s another way of saying, “wow, this business isn’t as risky as the market thinks, so I can buy it at a discount and earn its intrinsic value in cash flow.”
That might be correct, but I think it’s selling yourself short.
If I’m going to commit the time & effort into the deal, I need to see a credible path to increasing intrinsic value of the business. In fact, I’m willing to make a worse trade (pay 5x for a business that is worth 5x) if I see that path.
I’m willing to make a worse trade but a better investment because a trade has limited upside. A trade’s upside is just the gap between your purchase price and intrinsic value.
An investment has unlimited upside — the gap between your purchase price and however much you can increase intrinsic value.
So if I have to pick one to focus my time & effort on for the next 5+ years of my life, I’m picking an investment.
Conclusion
If you read Tuesday’s post, this framework dovetails with my broader point that I am looking for deals with real upside skew. Today’s post is just another way to skin that cat.
Hope this week’s two posts on investing philosophies will help you sharpen your pencils on the next deal!
I’m always around if you’ve got questions or feedback. Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, ideally located in the Northeast, West Coast, or Colorado).