In my previous article, I shared my notes on Tom Gaynor’s talk at Google. He talked about how he went from value spotter to spotting the creation of value. This made me think about how exactly value is created over time, because if we think about it, we have to know how value is created before we spot it. This leads me to the following observations of how value can be created. I’m sure this is not a complete list, so I welcome readers for additions.
Business Model related:
- Consistently earn good return on invested capital.
- Consistently lowering per unit cost of sales with growing or flat sales.
- Growing sales at a faster rate than the growth rates of expenses.
- Consistently lowering SG&A% and other non-COGS expense items as % of sales without hurting sales through productivity improvement or automation.
- Increase price every year without hurting volume and without significant investment in capital.
Capital allocation related:
- Spinning off segments to eliminate the conglomerate discount or getting rid of the inferior business.
- Using stocks to acquire stocks of companies with lower earnings multiples.
- Acquiring underperforming companies and improve operations.
- Buying back shares below the intrinsic value of the business.
Both business model and capital allocation:
- Reinvesting the earnings at a higher rate on cost of capital.
- Taking on leverage (borrowing money) and use the proceeds to invest in higher-than-cost-of-borrowing-return projects than the cost of borrowing.
- Acquiring great operational businesses and improve capital allocation capabilities.
- Having more business done in a lower-tax environment domicile.
It is very rare if a company can check off a few of the items on the list. Coca-Cola (KO, Financial) and Brown Forman (BF.B, Financial) can check off the following items:
- Consistently earn good return on invested capital.
- Growing sales at a faster rate than the growth rates of expenses.
- Reinvesting the earnings a higher rate on cost of capital.
- Consistently lowering per unit cost of sales with growing or flat sales.
- Consistently lowering SG&A% and other non-COGS expense items as % of sales without hurting sales through productivity improvement or automation.
- Increase price every year without hurting volume and without significant investment in capital.
- Buying back shares below the intrinsic value of the business.
Berkshire Hathaway (BRK.B, Financial), on the other hand, will check off the following items:
- Consistently earn good return on invested capital.
- Reinvesting the earnings a higher rate on cost of capital
- Taking on leverage (borrowing money) and use the proceeds to invest in higher-than-cost-of-borrowing-return projects than the cost of borrowing
- Acquiring great operational businesses and improve capital allocation capabilities.
- Increase price every year without hurting volume and without significant investment in capital (this only applies to some of Berkshire’s subsidiaries).
Markel (MKL, Financial), at the current structure will probably only check off the following items:
- Consistently earn good return on invested capital.
- Reinvesting the earnings a higher rate on cost of capital
- Taking on leverage (borrowing money) and use the proceeds to invest in higher-than-cost-of-borrowing-return projects than the cost of borrowing
Sometimes a company will not check off any items. These companies will often look very cheap on a quantitative basis, but they are cheap for a great reason. It’s much harder to calculate the intrinsic value of those businesses as time is truly the enemy of lousy businesses. But if you have a company that can create value in many of the aforementioned ways, time is truly your friend.
