In a merger or an acquisition, shares can be used as currency to buy the target company without having to pay cash. If company A wants to acquire company B using a share-swap deal, A gives B’s shareholders some of its own shares in exchange for each share of B they own. B shares cease to exist after the deal.
In his letter to the shareholders, Buffett said many times, when conglomerates are required to pay staggering premiums to acquire a company, they simply manufacture a vastly overvalued stock of their own that could be used as a currency for pricey acquisitions.
“Often, the tools for fostering the overvaluation of a conglomerate’s stock involved promotional techniques and ‘imaginative’ accounting maneuvers that were, at best, deceptive and that sometimes crossed the line into fraud,” said Buffett. “When these tricks were ‘successful’, the conglomerate pushed its own stock to, say, 3x its business value in order to offer the target 2x its value.”
Buffett blames Wall Street’s thirst for fees income on the deals and the media’s hunger of eyeball grabbing headlines for such deals, which defy logic.
“Investing illusions can continue for a surprisingly long time. Wall Street loves the fees that deal-making generates, and the press loves the stories that colorful promoters provide. At a point, also, the soaring price of a promoted stock can itself become the ‘proof’ that an illusion is reality,” the Oracle of Omaha said.
He further added that these practices give conglomerates their terrible reputation.
“Financial history is replete with the names of famous conglomerateurs who were initially lionized as business geniuses by journalists, analysts and investment bankers, but whose creations ended up as business junkyards.”
It should be noted that Buffett himself has been a party to at least one share swap deal. In 1993, the company acquired privately held Dexter Shoe Company by issuing 25,221 shares of Berkshire Hathaway, which valued the deal at around $420 million.
However, in his 2008 annual letter, Buffett called the purchase his “worst deal” ever, saying he had bought a “worthless business” and compounded his error by using Berkshire stock rather than cash to fund the acquisition.