I see what you're saying. And I don't exactly disagree.
Trying to convert Buffett's pronouncements and actual investments into an actual investing process is the holy grail. Sometimes I think he is intentionally sphinx-like. Other times I think he has trouble articulating his investment steps because they are so internalized because he has been doing it for so long. Alice Schroeder touches on this in the Mid Continent Tab Company presentation. If that book does come out, it will be very helpful.
Speaking of that case study, don't you think he (uses) an earnings power value method in a sense? Isn't he backing out all growth, and assessing the value of the company based on its sustainable level of earnings?
But the difference between most investors and Warren Buffett is that most investors are thinking purely in terms of earnings power. They’re thinking let’s just calculate normalized earnings and then slap a P/E on that sucker.
Warren Buffett thinks like a businessman. That means thinking in terms of return on capital.
Obviously, return on capital matters most in the long-run. Return on capital is your long-run destiny in any investment. If you buy a stock and hold it for 50 years, the price you pay – the P/E – is going to be less important than the return the company gets on the capital it keeps in the business over those 50 years.
Here’s what Warren Buffett said in 2009:
So what Buffett is really doing is a return on capital calculation.
Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.
Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.
A return on capital calculation is a little bit more involved than an earnings power calculation.
In the Mid-Continent Tab Card Company example, Buffett is saying what is sales/assets and what's the profit margin. If the profit margin gets cut in half, I've still got sufficient asset turnover on the lower profit margin to have an acceptable return on my own investment in years 2 and 3.
People make the math more exact than it needs to be. You don’t need to write down any actual numbers as long as you can just sketch out the key lines in your mind’s eye.
Basically, your annual return in a stock has 3 limits:
- The initial yield you – the owner – are getting the stock at
- The business's own return on capital
- The business’s future growth/decay rate
So, for instance, if you buy a stock that has an 11% return on equity at an appropriate leverage ratio and you buy that stock at a price-to-owner earnings ratio of 4.5, you have an long-run limit of an 11% annual return and a short-term limit of a 22% annual return (1/4.5 = 22.22%).
Obviously, I don’t mean the limit is an actual maximum return cap. Of course, you can flip the stock to a greater fool. That’s not what we’re talking about here. We’re saying that your annual return on a stock will tend to be drawn to those 3 lines: initial yield, return on capital, growth/decay. Those are the 3 magnets pulling your annual return in different directions.
The owner earnings yield is the short-term return line. If none of the earnings are reinvested that’s what you’ll get paid every year.
The business’s own return on capital is the long-term return line. If all of the earnings are reinvested that’s what you’ll get paid every year.
No, they won’t literally mail you a check. But the value of your investment will grow at the business’s own return on capital.
Now, I know what you’re thinking. Don’t we have to use the marginal return on capital?
I’m not sure we do.
The marginal return on capital is nice in theory. But that’s not really how a business uses capital. If a business is unleveraged and has a 60% return on tangible capital, it can actually take capital out of the business and pay owners simply by adding debt and using the 60% return to pay the interest.
In other words, the marginal return on capital doesn’t have to be the return on capital you add. It can also be the return on capital from literally returning capital to owners. The margin swings either way. In really good businesses, you can often pay out capital by simply earning the same amount on less invested capital provided by owners.
You can do this by either literally removing capital relative to the volume of business done or by removing equity and replacing it with debt.
When I hear economists talk about the marginal return on capital, I don’t hear them talk much about the possibility of earning that return by spitting capital out instead of taking it in. But that’s actually a very common way for getting terrific long-term returns through owning a business. Just don’t add capital.
That’s how Warren Buffett made a bundle on the Washington Post (WPO) and See’s Candies. The marginal return on capital was not high. But the need to add capital was almost non-existent. Over time, the Washington Post bought back about half its shares. That was how it used capital. It didn’t reinvest in the business directly. It just reinvested in its own business on behalf of its remaining shareholders by using the free cash flow they had allowed The Washington Post to retain. So, shareholders got their earnings reinvested in the business, but the business didn’t have to actually grow. Teledyne did the same thing. And you know how much Warren Buffett thought of Henry Singleton.
So, when we talk about the marginal return on capital, there is always at least two doors for a public company to choose from. It can reinvest in the business directly by putting capital to work. Or it can reinvest in the business indirectly by buying back shares. That means there can’t be just one marginal return on capital in a business. There have to be multiple marginal returns on capital depending on where the capital is directed – not just where inside the business – but where outside the business as well.
One reason Fair Isaac (FICO) is interesting right now, is the change in capital allocation it’s made under new management. From 1999-2007, it was doing really awful things with its capital. Last year it bought back 17% of its shares at rock bottom prices. That’s a big difference that totally changes the calculus for investors in Fair Isaac. It’s like a completely different company now, because instead of issuing shares as it did about a decade ago – it’s now buying them back. Years ago, FICO was actually de-investing its shareholders’ money in the core business. Now, the door is swinging the other way and capital is being used to buy more of the company’s own business for the remaining shareholders. FICO may be essentially the same business. But it’s now a fundamentally different stock. Where FICO’s investors are headed and at what speed is now totally different from what it was just a few years ago.
That’s all due to capital allocation.
So forget about the marginal rate. You can’t look at the velocity of something when you don’t know the direction it’s headed and when the speed changes whenever the direction changes. But that’s exactly the situation with any stock investment. There are so many directions and so many different speeds at which capital can compound, that the idea of a single marginal return on capital is bonkers. If anything, there are a range of possible directions for capital to move and speeds at which capital can compound.
Thinking about return on capital is more of a bridge game than a math problem. You’re thinking about the personalities involved, their history, the different ways they can play the hand their dealt, and then – yes – also the math involved with different choices. But a lot of it is communication. Do I know how management will use their capital? Will they be shown a lot of dumb choices in this kind of industry? Are they the kind of folks who will make a dumb choice – who will leap into some new direction I don’t want my capital going?
Now, I may be projecting myself on to Warren Buffett here. Because this is something I think about a lot. One reason I prefer investing in companies where a single shareholder – or a family – owns anywhere from 30% to a majority stake in a business is that I can look at their capital allocation history and I can imagine the path my capital will take when they’re steering the ship.
Big companies run by professional managers are the worst this way. These guys can do anything with your capital. Sometimes there’s a good, strong tradition of prudent capital allocation even at professionally managed companies. But that’s actually pretty rare. Generally, I prefer a king to a president. The king doesn’t have to run the country day to day. But at least he won’t let anybody carve up the homeland.
Where you don’t have a king – where you have no major shareholder exerting influence – it becomes incredibly difficult to predict future returns on capital. The problem isn’t math. It’s psychology. Even if I know what the returns on capital are for each possible direction, how do I know which way the captain will steer the ship?
The range of future return on capital possibilities looks like someone fired a shotgun. I want more of a sniper rifle pattern. I don’t want possible outcomes spread across every quadrant. I just want a nice clump of adequate possible outcomes.
So I’m willing to pay up big time when I know both the direction and the speed of capital compounding. When a company has a record of using all its free cash flow to buy back stock, I’m willing to get on board that train because I know it’s headed at 12% a year – or whatever – in the direction of just giving me a bigger piece of the same pie.
Likewise, I’ll pay up for reinvestment in rolling out the same proven store design at more and more locations around the country. Unfortunately, everybody agrees with me on that one. So, I’m usually unable to handicap a retailer or restaurant stock which I know will grow, but I don’t know if it will grow enough to justify it’s already very high price.
That brings me to growth. Now, the growth/decay rate is really complicated because it tends to be self-defeating. There are exceptions. But if you know the future is trains or cars or planes or semiconductors – so does everyone else. And the market will grow and grow. And that growth will kill one company after another.
It’s probably better to think of demography than math when thinking about a company’s future growth. Growth sounds good. Now imagine population growth.
Is population growth always good?
Is a country growing its population at 3% a year really someplace you want to live?
Here are some examples: United Arab Emirates, Ethiopia, Congo.
Now I’m not saying those countries are any better off or worse off than their peers. I am saying they’ve got domestic issues to deal with because of that population growth. Just like Japan and Russia have their problems with population decay, the U.A.E., Ethiopia, and Congo have problems with high population growth.
Both forms of change – growth and decay – are destabilizing. Some parts of the whole don’t move in lockstep with the others. You end up with lots of old people or lots of young people. Lots of unemployment or lots of retirees to support.
It’s easier to evaluate a country like the United States, because it has a much more stable population growth trajectory than Russia, Japan, the U.A.E, Ethiopia, or Congo.
And it’s much easier to evaluate Kimberly Clark (KMB) than Apple (AAPL) for the same reason.
There’s nothing necessarily wrong with growing your country’s population at 3% a year. But it creates problems. It creates exciting growth opportunities. And it creates maddening bottlenecks.
When a company, or a product, or an industry grows faster than the overall economy, it brings both exciting growth and serious problems.
The growth/decay rate is complicated, because growth and decay are often the very things that raise or lower the return on capital by raising or lowering the amount of capital in the business.
For instance, it's not uncommon for a net-net to eventually - over 3 or 5 or 10 years - improve its return on capital simply by slowly self-liquidating as the business decays in real terms. Free cash flow constantly exceeds net income as the companies bloated inventories and receivables are cut down to size year after year.
Conversely, something like AT&T or the railroads or cruise lines at different times in their history have put too much capital into a growing business too fast and therefore growth has lowered the rate of return on the capital in the business even while the business grows in real terms. In those cases, free cash flow trailed net income – year after year – in a huge way and owners often benefited less than customers.
I can predict a company like Carnival (CCL) will grow and grow its sales and earnings year after year. Unfortunately, I can also predict a company like Carnival will grow and grow its invested assets year after year.
Because Carnival’s return on its invested tangible assets is so low, I’m not convinced growth will add value at Carnival unless the company increases its asset turnover ratio (sales/assets). The current asset turnover ratio at Carnival is too low to make growth profitable unless the company really leverages its equity at least as much as a railroad – maybe more.
Basically, an earnings power based stock investment boils down to:
- Inside Coupon
- Outside Coupon
- Coupon Growth/Decay Rate
If you look at the way Warren Buffett actually talks, I definitely don't get the impression he ever looks at earnings power apart from capital. He thinks in terms of the return on capital in the business and the price you are paying for that capital. Something like Burlington Northern is only attractive because it can be safely leveraged. So, Berkshire's return on its investment may be decent - not extraordinary - because it's leveraging the low returns on tangible assets employed into adequate returns on Berkshire's investment in BNSF.
That's where things get tricky. There's no perfect measure of a business's own return on capital from an owner’s perspective. You can value mundane industrial businesses using EBIT/Total Tangible Assets Employed but you can't do that with utilities, railroads, and financial companies because they can use a lot of leverage even under "normal" conditions.
But as we know from all the banks, utilities, and railroads that have failed – there’s a limit to how much leverage you can use.
Nonetheless, Warren Buffett obviously looks at the return on equity if he thinks the business isn’t overleveraged. Unfortunately, that means there is no one magic formula for valuing every kind of business. It depends on how much leverage they can use.
Basically, I would say Warren Buffett is a return on capital investor not an earnings power investor. Yes, the two ideas are very closely connected. But the connection isn't perfect. And most of what Buffett seems to be doing when he thinks about the future is not thinking just about growth but instead thinking about what the future relationship between the capital inside the business and the cash flows coming out of the business will be.
I may be biased here.
Personally, if a genie could tell me what a company's growth rate would be for the next 30 years or what a company's return on capital would be for the next 30 years, I'd rather know the return on capital.
It's very hard to know both.
Sometimes you can know the return on capital and guess that growth will be in line with nominal GDP, inflation, or inflation plus population growth. I think it's very hard to know more than that. Usually, when you know what the future growth rate will be you don't know what the future return on capital will be and vice versa.
That makes sense, because in a competitive ecosystem, return on capital and growth should undermine each other.
There are exceptions.
Right now, Fair Isaac (FICO) and PetMed Express (PETS) are two very interesting exceptions. They are high return on capital businesses with substantial mindshare. FICO operates in a stable competitive ecosystem. 1-800-PetMeds does not. But here’s the catch. 1-800-PetMeds operates in a fragmented competitive ecosystem.
Fragmentation changes everything. Especially if some of those competitive fragments are locked into the wrong distribution system.
The vets are going to get creamed. So you don’t have a situation with 1-800-PetMeds like you do with Apple. What you have is a situation where the overall market size will be pretty stable but the market share is going to shift.
New competitors are going to gobble the veterinarians’ pie. The vets are pinned down. Their competitors have complete mobility. It’s going to be a bloodbath.
Normally, the stock market handicaps that kind of situation well. At least well enough that I can’t find a stock that will gain so much competitively it will cover the spread – by beating the expectations baked into its stock price.
I think 1-800-PetMeds is an exception. And I only say this because I’ve watched the buying behavior of people who have pets. And I’ve given a lot of thought to that behavior. And basically, there’s no way vets will increase their share of pet medications. And there’s very little reason for anyone to buy from a general retailer. I don’t think people realize that. But it’s true.
Pet medications are a recurring purchase. They are ideally suited to being sold by a specialty retailer. They are also a somewhat infrequent purchase. It’s kind of unusual to have an infrequent but still regularly recurring purchase. So there aren’t really a lot of consumer behavior comps for pet medications.
There’s nothing stopping Wal-Mart or Amazon from selling pet medications, but there’s no reason for anyone to switch to using those companies.
And there are two very good reasons – price and convenience – for people to switch from using vets to using one of the other pet medication retailers.
And of course 1-800-PetMeds has the mindshare that’s impossible for a general retailer to ever have. By definition, general retailers can’t be associated with one product in the customer’s mind. That’s what makes them general.
So, that’s a rare situation where you have a high return on capital business that will probably stay a high return on capital business as it grows. Normally, it’s hard to know that ahead of time. Very rarely, like with 1-800-PetMeds it seems obvious there will be growth and it will be profitable.
But the scarcity of situations like 1-800-PetMeds is why it’s hard to buy growth stocks. When you know growth will be adequate, you usually can’t know that future returns on capital will be adequate. And even when you know both future growth and future returns on capital will be adequate, the current stock price is usually totally inadequate.
So even though you know which horse will win – you can’t bet on that horse.
If Warren Buffett were investing a much smaller amount of money than he does at Berkshire, I think he’d consider stocks like FICO and 1-800-PetMeds. Maybe not those exact stocks – though I have a feeling Buffett would like those exact stocks – but certainly stocks like them.
Stocks where he was getting an adequate return on capital and where he thought he understood the competitive ecosystem.
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