At Urbem, we believe that all intelligent investing is value investing, even with so-called growth stocks. Nonetheless, it is also to our belief that not all growths are created equal. A good business does not have to grow to stay "good." As growth usually requires the reinvestment of capital and the rate of return typically cannot remain high for an infinite period, management should always forgo low-return growth opportunities and return the capital to shareholders.
In his 2007 letter to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders, Warren Buffett (Trades, Portfolio) elaborated on the type of growth that he likes and the type that he wishes to avoid:
"Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.
At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
We bought See's for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See's sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth - and somewhat immodest financial growth - of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)"
Great businesses are a scarce species. They manage to grow even with minimal capital reinvested while returning tons of cash to owners. According to Mr. Buffett, they are comparable to a high-yield saving account, with the rate even trending up every year. However, as you may have imagined, investors seldom find such saving accounts in the stock market:
"There aren't many See's in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That's because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft (MSFT, Financial) or Google (GOOG, Financial)(GOOGL, Financial).
One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See's-like, return on our incremental investment of $509 million."
Good businesses need a decent amount of capital to grow but still manage to generate high returns on reinvested capital. By nature, they are the high-yield savings account with a fixed rate. Despite the lower attractiveness of such investment opportunities compared to the great businesses, the bright side is that the account accepts new deposits so that shareholders can grow their earnings in a compounded way.
Now can you imagine the worst savings account ever? It's the type with a low fixed rate that requires you to add deposits every year:
"Now let's move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
The airline industry's demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice."
We call such businesses a “growth trap.” They may increase earnings from year to year, but their returns are inadequate. The more rapidly they grow, the more shareholder value they destroy.
At Urbem, we strive to search for the savings accounts of great businesses by examining both quantitative and qualitative factors, including management’s capital allocation skill, the capital-intensity of the business and long-term growth prospects. We were fortunate to encounter a couple of See’s-like companies, such as OTC Markets Group (OTCM, Financial). Being genuine wealth-creators, these businesses have significantly increased their annual free cash flow without the need to reinvest much capital.
Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we own shares of Berkshire Hathaway and OTC Markets Group.
Read more here:
- Urbem's 'Wonderful Business' Series: Bioventix
- Urbem's 'Wonderful Business' Series: Nichols
- Urbem's 'Wonderful Business' Series: Rational
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