It's no secret that Warren Buffett (Trades, Portfolio)'s favourite businesses are those companies that produce a lot of free cash flow and generate a high return on tangible assets. These sorts of companies feature heavily in Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) portfolio and have helped contribute to his incredible success over the past few decades.
However, in recent years, the conglomerate has started to move away from these types of businesses. As it has accumulated so much capital, it has become harder and harder for Berkshire to deploy the tens of billions of dollars in cash Berkshire is throwing off every year into high return businesses.
Instead, Buffett and his team have concentrated on deploying this capital in more stable sectors such as utilities and infrastructure. These assets might not produce as much of a return compared to companies such as See's Candies, but they do offer an attractive return compared to the interest rates available on the market today.
Buffett explained at the 2012 Berkshire annual meeting that while the rate of return available on these assets was not as high as he might have liked, it was still "perfectly satisfactory." Specifically, he said:
"In the electric utility business, you know, we can expect, cash retained to perhaps earn an average of 12% or something like that, which we regard as quite satisfactory. It's not as exciting as having some business that's going to grow 20% a year and not require any capital. I mean, there are a few wonderful businesses like that, but it's perfectly satisfactory.
Same way with the railroad business. You know, we are going to invest a lot of capital over the next 10 years in railroads. Every year we will spend way more than depreciation charges. I think the prospect of earning reasonable returns on that are pretty darn good."
However, Buffett when on to caution that while he was relatively happy with this "satisfactory" rate of return, he would not put up with a business that consumes more capital than it generates:
"But if I had to put a lot of money, you know, into some capital intensive business where all we were doing was staying alive with that money, you know, we would be in a terrible situation."
Focus on the cash return
This should be a lesson all investors understand. Everyone wants to own a business that earns a double-digit return on capital.
Unfortunately, the fact of the matter is that there are just not enough of these businesses to go around. Some investors and business owners will have to put up with a much lower return on capital. A double-digit percentage return is still desirable. A mid-single-digit return could also yield desirable results over the long term.
However, any company that consumes more capital than it generates is never going to be a good investment. It will require either more capital to be put in by the investors or more borrowing. There are quite a few businesses in different sectors that fall into this bracket.
The mining sector is a great example. Even though the industry has tried to rationalize over the past five years, during the first 15 years of this millennium, many projects failed to earn a return on capital as mining groups chased expensive vanity projects in an attempt to push up sales at all costs. The bubble eventually collapsed, and shareholders had to pick up the bill.
Low margin engineering and industrial businesses have similar traits, and so do oil companies.
Finding good companies that can earn 20% on reinvested capital can be tough, but staying away from these bad operations is much easier. That might be the better course of action for investors over the long run.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Charlie Munger on the Art of Stock Picking
- The Culture Behind Amazon's Success
- Was Warren Buffet Right to Sell His Airline Stocks?
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