"[I]nvestors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss a toad, those kisses had better pack some real dynamite. We've observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses -- even after their corporate backyards are knee-deep in unresponsive toads." -- Warren Buffett, 1982 

Wall Street loves mergers and acquisitions. This type of activity generates lots of banking fees and can provide a shot in the arm to trading revenue. However, it's much less common that M&A activity benefits long-term investors.

That's why Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) CEO Warren Buffett is suspicious of most mergers and acquisitions activity -- even though Berkshire Hathaway has bought up plenty of companies under Buffett's leadership!


Warren Buffett is wary of buying struggling companies (Photo: The Motley Fool)

Buffett is particularly wary of companies that acquire underperforming businesses and hope to fix them or improve their profitability through "synergies." The sad corporate history of Sears Holdings (NASDAQ:SHLD) shows exactly why Buffett has been wise to focus his own acquisition efforts on strong businesses.

The Frog Prince is just a fairy tale!
In his 1981 letter to Berkshire Hathaway shareholders, Warren Buffett hypothesizes that many corporate executives were captivated by the fairy tale The Frog Prince as children. In the most common modern version of the story, a prince is trapped in a frog's body, but the spell is released when a princess kisses the frog.

According to Buffett, many corporate CEOs seem to believe that they are the princess from the fairy tale. They buy up weak companies, thinking that their "kiss" can turn these apparent frogs (or toads) into princes. Unfortunately, they're just frogs -- and they eventually turn into dead frogs!

Buffett points out that there are typically lots of struggling companies with low stock prices at any point in time. If people want to buy shares in these companies, they can buy shares on the cheap.

However, when these struggling companies are acquired outright, the purchaser almost invariably ends up paying a premium. Why would a CEO pay a premium to acquire a struggling business? This behavior only makes sense if corporate CEOs believe that they can wring profits out of companies that aren't making much money on their own.

Sears Holdings is a perfect example
In late 2004, hedge fund manager Eddie Lampert was featured on the cover of Businessweek in a story touting him as the next Warren Buffett. The story came out shortly after Kmart, which was controlled by Lampert's hedge fund ESL Investments, reached a deal to buy Sears (another big Lampert stock holding) to create Sears Holdings -- which was supposedly destined to be the next Berkshire Hathaway.


Eddie Lampert paid more than $11 billion to buy Sears, despite its struggles (Photo: The Motley Fool)

Kmart, the smaller of the two, agreed to pay more than $11 billion in cash and stock for Sears. While both companies were struggling, Kmart seemed to be in the midst of a turnaround. Lampert believed he could create revenue and cost synergies by merging the two and selling each retailer's exclusive products at the other.

Unfortunately, Lampert hadn't heeded Warren Buffett's advice about paying top dollar for weak businesses. In the ensuing decade, Lampert cut billions of dollars in costs, but that hasn't made Sears a cash cow. In fact, Sears Holdings' market cap is now $4 billion -- less than half of what Lampert paid for the Sears portion of the business, and down almost 80% from the peak in 2007.

SHLD Market Cap Chart

SHLD Market Cap, data by YCharts

Indeed, Lampert's giant bet on turning around two underperforming retailers through a merger has nullified a lot of his victories. Many of his wealthiest clients have pulled money out of ESL investments in recent years. Meanwhile, he has had to step in as CEO of Sears Holdings, which hasn't done anything to stop the bleeding.

All told, the Sears Holdings stock price today is lower than its predecessor's (Kmart Holdings) stock price 10 years ago -- shortly before the Kmart-Sears merger and the Businessweek profile. Meanwhile, the market as a whole is up more than 75%.

SHLD Chart

Sears Holdings vs. S&P 500, data by YCharts

Foolish bottom line
Deep value investors can occasionally find diamonds in the rough: businesses that appear to be struggling but have good long-term prospects. These stocks can be huge winners. However, some "deep value" investments turn out to be duds after all. As a result, Buffett has been willing to pay a premium at Berkshire Hathaway for high-quality stocks with defensible moats.

However, the worst of both worlds is paying a premium to buy a struggling business in the hope of turning it around or wringing out merger synergies to justify the price. Buffett likens such behavior to hoping you can turn a frog into a prince with a magical kiss. Eddie Lampert's failed strategy at Sears Holdings shows just how dangerous such a strategy can be.

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Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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