‘He that has once done you a kindness will be more ready to do you another, than he whom you yourself have obliged’ wrote Benjamin Franklin in the late 18th century, and the ‘Franklin Effect’ was born. One may well do nice things to people one likes, but one definitely grows to like people to whom one does nice things; and, conversely, to dislike people one harms. Acts tend to be naturally rationalized, whether generous or cruel. Examples:
Those who attended the 2012 Olympic Games in London were unanimously impressed by the quality of the service provided by the 70,000 volunteers. I remember thinking that if the staff had instead been paid £10 an hour, their contribution would not have been that exceptional. Because they gifted their own time, and did a nice thing to support the Games, the volunteers saw the event as even more exceptional than it was so as to rationalize their sacrifice. They then acted accordingly by behaving with the highest standard of professionalism. What I did not know back then is that I was witnessing the Franklin Effect in full swing. The very same explains why unpaid interns work so hard (check also the ‘Measures of Performance’ experiment at Stanford)
The infamous 1971 Stanford Prison Experiment is another example. There, students were asked to simulate a prison environment by acting as either guards or prisoners. The guards got carried away within hours: since induced to perform unkind behaviors they developed a deeply unkind attitude towards prisoners. In that respect, the 2014 Abu Ghraib scandal – and more generally, war atrocities – can be seen as an expression of the Franklin Effect gone berserk
It seems to me that the same inner workings of the mind have deep implications for pricing strategies, stock market valuations and M&A. Basically, one grows to value things which require a real investment and to poorly rate those which come at a low cost:
It has been scientifically established that the same wine or pizza does taste better if priced dearly rather than cheaply. The purchase of a premium item is rationalized by it actually looking, feeling, smelling or tasting better than a commoditized alternative. Luxury brands discovered this principle a long time ago. The higher the price of so-called aspirational goods, the higher their ‘perceived value’ and the more satisfaction may be derived by the purchaser – and, conveniently, by the manufacturer. The applicability of such pricing strategy to industrial goods should be admittedly nuanced, though the fundamental psychological concept must remain valid
The same Franklin Effect would support the growing market dichotomy within the Diversified Industrials space identified in last week’s Sunday note: High quality industrials have been trading at an increasing premium to the broader market. Why? Because they must be worth it, of course. Buy! As for food, the more expensive these companies are, the more they are deemed to be of quality by investors. Needless to say, any high quality company failing to deliver according to the highest expectations would be immediately and dramatically downgraded, potentially sending it into a tailspin. If it is cheap, it is probably because it is of relatively poor quality. Sell!
In 1999 I was selling my first company, the industrial battery manufacturer SAFT, on behalf of Alcatel. When final bids were received after a full-blown auction process and turned out to be above everyone’s expectations, Alcatel decided that SAFT was actually a great asset worth retaining in its portfolio despite the significant opportunity costs. Thank you, Mr. Franklin. As it relates to acquisitions, a target acquired at a 20x EBITDA has got to be a fantastic asset. And the acquirer’s shareholders may not disagree with that assessment, since the same investors value a number of high quality industrials in the public market at these levels today. Furthermore, a company acquiring exceptional assets must be exceptional itself, mustn’t it?
Do acquirers overpay by purchasing high quality assets at a large premium? Unlikely so, provided of course that the target is truly exceptional since extraordinary valuation multiples must be ordinary for extraordinary assets. Fundamentally, value is a much more subjective concept than narrow micro-economic and corporate finance principles suggest it. This is true for pizzas, luxury items and entire companies. The emotional connection with a product or a company at an individual and stakeholder level can last if nurtured and should never be underestimated. Truth is, the difference between ‘value’ and ‘perceived value’ is a rather academic one.