-Charlie Munger (Trades, Portfolio), 2008 Berkshire Hathaway Annual Meeting
I’m patiently looking for bargains everywhere. That’s the name of this game: "figuring out what something is worth and paying a lot less for it," as Joel Greenblatt (Trades, Portfolio) says. But everyone wants to be more specific… Ideally, what I like to invest in are compounders. What are compounders? Very simply, they are high quality businesses that can grow their intrinsic value at high rates of return over long periods of time. A business that can grow intrinsic value at say 12-15% over an extended period of time will create enormous wealth for its owners over time, regardless of what the economy does, or what the stock market does, or what earnings multiples do , etc…
I like a business that produces high returns on capital and consistent free cash flow. Like Charlie Munger (Trades, Portfolio) says, we want to find businesses that can write us a check at the end of the year. I love this simple explanation, and it’s one that I always keep in mind, and it’s a good starting point—a conservatively financed business that can write you a check every year (i.e. produce more cash from operations than it needs to maintain its current competitive position) is unlikely to get you into trouble. That’s why I like keeping a list of businesses that have produced 10 consecutive years of free cash flow.
Cash Flow is Nice, Reinvestment Opportunities Are Better
I love the business Munger talks about that cuts me a check every year from its consistent and stable cash flow. But ideally, I’m looking for businesses that will forego sending me a check because of the attractive reinvestment opportunities that it has within the business itself. In other words, I would prefer a business that not only produces high returns on invested capital, but can also reinvest a large portion of its earnings at similar high returns. This is where a business achieves the true compounding power. Typically, these compounders enjoy a niche or some kind of competitive advantage that allows them to achieve consistent high returns on capital.
So it’s really nothing different from what most other investors and business owners want: quality businesses that will produce high returns on invested capital with attractive opportunities to reinvest earnings, which leads to value creation (higher earnings over time).
This gets discussed often, and the variables involved with businesses achieving this type of compounding power are sometimes difficult to ascertain and even harder to predict going forward. But the math is quite simple: A business’ compounding power can be calculated by three simple factors:
- The percentage of earnings that a business can reinvest back into the business
- The return that the business can achieve on this investment
- What the business does with excess cash flow (if the reinvestment rate is less than 100%)
The Math of Intrinsic Value Compounding
I recently read something that used some examples to illustrate this compounding formula. Basically, the compounding effect is the product of the first two factors: return on capital and the reinvestment rate. If a business can achieve 20% incremental returns on capital and it can reinvest 50% of its earnings each year, the intrinsic value of the business will compound by 10% annually (20% x 50%).
Similarly, a business that can reinvest 100% of its earnings at 10% returns will see the value of its enterprise also compound at 10% annually (100% x 10%). Note: the first business is better because the higher ROIC and lower reinvestment rate means that 50% of the earnings can be used for either buybacks or dividends (or value creating investments).
ROIC is the Most Important Factor
But it’s crucial to understand the math… the math suggests that return on capital is the most important factor. A business that produces 6% returns on capital is simply not going to compound its owners’ value at attractive rates, regardless of how much or how little it can reinvest. But a business that produces 30% returns on capital will likely see the intrinsic value of its enterprise increase at high rates of return (even if it can only reinvest half of its earnings, the enterprise itself will grow at 15% annually, and the company will be able to create additional value by buying back shares or issuing dividends with the other half of the earnings).
So this hopefully illustrates why return on capital is such an important concept and why Buffett, Greenblatt, and even Graham often discussed it.
The key question is what to pay for a business like this. We haven’t discussed valuation. Ideally, I’m looking to be opportunistic with my investments, meaning that even with what I consider to be great businesses, I want to buy them cheaply because it dramatically increases the margin of safety in the event that you made an error in your analysis.
In other words, we want to locate quality businesses with high returns on capital, but we want to pay low price relative to the earning power of these businesses, as this gives us two things:
- A margin of safety if we were wrong about the quality or sustainability of the business’ return on capital
- The benefit of much higher returns if we were in fact right about the business
Some investors say that they don’t care about quality, only valuation. This has been shown to be true in various backtests, although most of the tests are short term in nature (usually 1-2 years). I think there are serious flaws in the logic of abandoning quality—and serious risks as a result. After all, quality, like growth, is a part of valuation. Too many investors get caught up in the simple metrics and assume that quality in mutually exclusive from valuation. It’s very much inclusive…
But that aside, it’s fairly logical that we would prefer—as business owners—to own quality businesses over mediocre businesses—valuations being equal.
How Much To Pay?
The question is what price to pay, and my general answer is that it depends on the business and the specific investment. I try to imagine what the business and its normal earning power would be worth to a private owner. I really look at each investment on its own--not as part of a larger portfolio. Each investment has to stand on its own.
When it comes to valuation, I've heard some people say that for quality businesses, they don't want to pay more than an average valuation of around say a 6-7% normal cash earnings yield (the so called "good business at a fair price"). I don't really use this type of thinking, but I think a 10% pretax earnings yield (something Buffett uses as a rule of thumb) is a fair guidepost for a quality business that is growing. This isn't cheap, I know. It's why I think of each investment differently. Graham had earnings multiple rules of thumb, Buffett has his rules of thumb, and I think they might be helpful in ensuring that you don't overpay for what looks like a great business. But keep in mind those are rules of thumb. Some businesses are worth more. Most are worth less.
Think About Durability of Earning Power
As I’ll show in another post, the math behind choosing the “right business” is very compelling—it’s far more important to invest in the right business than it is to worry about whether to pay 10x or 12x or 14x earnings. It’s just that paying a low price protects us from our errors. The problem most investors have is that they are good at paying low prices, but bad at determining whether this low price corresponds to a large gap between price and value. There are lots of mediocre businesses available at 10x earnings, which will lead to mediocre results over time for long term owners.
The quality, the durability, and the earning power of a business are very important factors in assessing the margin of safety of the investment. Every bit as important as determining the normal earnings yield.
Compounders vs. "Special Situations"
Quality businesses will create more value for owners than mediocre businesses (groundbreaking news, I know...). So as a long term owner, I'd much prefer the former over the latter, almost regardless of how cheap the latter gets. A business that is shrinking its intrinsic value means that time is your enemy--you must sell as soon as you can because the longer you hold it, the lower the intrinsic value becomes.
But, flipping stocks might be a different story… it’s possible to buy a bad business at 8x earnings and sell it at 12x, yielding a nice 50% return. However, I find it much more comfortable and suitable to my personality to be able to garner investment results that correspond to the internal results of the business, as this eliminates the need to be right about timing, and it eliminates the need to constantly be producing good investment ideas—which is a difficult task to begin with.
In short, I like having my stocks do the work for me.
Of course, this is ideal, and not everything is ideal, and it leads me to a secondary category of investments, which I’ll group together as “Special Situations”… a category that includes these cheap stocks that can be sold at a profit to a private owner. This subset of investments also includes sum of the parts ideas, cheap/hidden assets, corporate situations such as spinoffs, rights offerings, recapitalizations, tender offers, etc…
The difference between these two categories can be summarized using an analogy of the dairy farmer (who raises dairy cattle to produce consistent milk over time) vs. a cattle rancher (who raises beef cattle which are used for meat production). The dairy cow provides consistent milk over and over for long periods of time. The beef cow doesn’t produce cash flow, but provides a payoff when the beef gets sold.
The compounders are the investments that continually grow intrinsic value over long periods of time with corresponding shareholder results over time. The investor buys compounding machines to partner in a business as a part owner, reaping his or her rewards over time as the business compounds in value. There is not an exit strategy in mind at the time of purchase with these types of businesses. It doesn’t mean they get held forever, but the idea is to compound your investment over long periods of time through the business’s results. The special situations are investments which are bought to be sold to someone else at a higher price.
But even in these "special situation" investments, I tend to keep in mind the same general business principles discussed above. Each investment is unique, but the principles are generally the same.
To Sum It Up
I look at a lot of undervalued situations and various opportunities, but I prefer investing for the long term—partnering with good management who are owner operators of high quality businesses with high returns on capital and attractive reinvestment opportunities.
The math is simple, and it exemplifies the importance of owning a business that can reinvest earnings at high rates of return—a situation that will create a compounding intrinsic value over time.
Some Other Posts in This ROIC Series:
- Importance of ROIC Part 1
- Importance of ROIC Part 2
- Thoughts on Return on Capital and Greenblatt’s Magic Formula Part 1
- Thoughts on Return on Capital and Greenblatt’s Magic Formula Part 2
- Buffett Shareholder Letter High ROE
- Wells Fargo vs. Small Community Banks
- A Few Thoughts on Buffett and Great Banks