“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”

–Warren Buffett, 2007 Shareholder Letter

A reader recently sent me the following clips from the 2007 Shareholder Letter that pertains to a topic that we’ve discussed quite a bit here: the concept of return on capital, why it’s important, and how to think about it.

For those interested, you could review all the previous posts on the concept of ROIC here.

Basically, I just thought I’d make a few brief comments on Buffett’s ideas here, but largely just clip a few portions of the letter, since I think this is a really useful topic to think about.

In this 2007 letter, Buffett groups businesses into three general categories based on their ROIC profile, and explains the differences between those three categories.

Category #1—High ROIC Businesses with Low Capital Requirements

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

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. 

Buffett then talks about the return on incremental capital and how he thinks about ROIC:

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.) 

I used this general back of the envelope math when thinking about return on capital (see this post for details on how I think about calculating incremental ROIC). It’s helpful to know roughly how much capital a business requires, how much of its earnings it can retain and reinvest, and what the returns from those investments will look like going forward.

So See’s invested an incremental $32 million over the life of the business which produced an additional $1.35 billion of aggregate profits over that time, an astronomically high return on capital. Obviously, See’s is a “capital light business” and the ROIC is high because the denominator is low. See’s couldn’t reinvest that cash flow at high rates of return, so it had to ship the cash to Omaha for Buffett to reinvest elsewhere.

Category #2—Businesses that Require Capital to Grow; Produce Adequate Returns on that Capital

Companies like See’s produce huge returns on the small amount of capital that it previously invested. These are rare businesses that can grow their earning power without capital investment. In See’s case, this was largely done through pricing power. But See’s is a rare business, and as Buffett points out, companies that can reinvest capital at high rates of return are still attractive businesses to own:

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 or Google. 

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. 

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it. 

Category #3—Businesses that Require Capital but Generates Low Returns

Here he uses the often-cited airline business as one that requires a lot of capital but can’t generate a decent return on that capital:

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. 

He sums it up by using a savings account analogy:

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns. 

What’s interesting is that Buffett talks about See’s as the most attractive type of business in this example, and certainly a business that produces steadily rising cash flow on a very low capital base is a great business. But a business that has the ability to retain and reinvest a large portion of its cash flow at high rates of return is also a great business in my view.

See’s is great because it produces cash flow without the need for capital investments, and it can still grow its earnings through pricing power. So this is truly an exceptional business. Moody’s might be a similar business—the ability to grow without new capital, which in essence means an infinitely high return on capital.

But those companies are incredibly rare birds. The next best business (and depending on the rate of return maybe even a better business) is one that can reinvest lots of capital at very high rates. This is where the compounding machine kicks into gear.

I used the example of CMG in the previous post mentioned above. The company had incredible attractive restaurant-level economics: it could set up a new location for around $800,000 and in the first year that restaurant would generate over $2 million in sales and $600,000 in cash flow, or a 75% return on capital.

Combine these high returns, with a long runway to put lots of capital to work (it was able to maintain these returns while growing from 500 stores to over 2000), and you have a formula for a compounding machine of great proportions.

CMG invested $1.25 billion during the decade between 2006-2015, an investment that led to $435 million of incremental earnings, an outstanding 35% return on incremental capital:


These high returns on capital led to steadily rising intrinsic value for the business over that time. In these types of businesses, requiring a lot of capital is a good thing (or at least certainly not a bad thing if it can be reinvested at 75% cash on cash returns).

Another example is Markel, an insurance business that is obviously much more capital intensive than See’s Candy, but yet has been an incredible compounding machine over the years thanks to its ability to retain its earnings and reinvest them back into the business at high rates of returns. The result of these high returns on incremental capital has been a steadily rising intrinsic value per share (and stock price):


Buffett himself described this type of business in an earlier letter (1992) when he said:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

So we might think two categories of great businesses:

  • Those that can retain and reinvest most/all of its earnings at high rates of returns
  • Those that don’t have any reinvestment ability within the business but can still grow earning power with little to no incremental capital

In a durable business with predictable cash flows, the latter category leads to a compounding effect that sees earning power per share impacted by the absolute growth of earnings as well as the steadily shrinking share count.

Both types of businesses are rare birds, but I would say the second category (the See’s or Moody’s type businesses that can produce sizable free cash flow using very little capital and can grow its earnings through pricing power) is exceedingly rare, but probably the most valuable.

A Few Other Posts on the topic of ROIC:

I also wrote a piece (Good Businesses Tend to Stay Good) on our new research site where Matt Brice and I discuss our investment ideas, share our research notes on the companies we follow, and discuss various investing topics with readers. That post discusses some research that (somewhat surprisingly) points to how high returns on capital are more sustainable than one might think, given the nature of capitalism.

Thanks for reading!


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

My good friend and fellow investment manager Matt Brice and I have decided to start a subscription-based sister site that we are calling the BHI Members Site. I’ve known Matt for a number of years now, and he and I think similarly when it comes to our approach to investing, which is focused on making a few select investments in high-quality companies that produce attractive returns on capital and, by our estimation, can continue to compound value going forward. Matt is one of the best investors I know, and he has produced net returns of over 25% annually since 2011 when he founded his investment firm The Sova Group.

So What is the Members Site?

Basically, it’s going to be a database of our investment ideas. The site will include:

  • All of our watchlists on the stocks we follow in various categories
  • Our database of great businesses we follow (around 50 of our favorite companies)
  • Our research notes on actionable ideas
  • Our scratch notes from our investment journals (notes on companies we are reading about)
  • An education section that will include investment theory posts and case studies

We will also begin (and have already begun) populating posts on our own summaries and comments on the Buffett partnerships and the Berkshire Hathaway letters. In addition to the Buffett letter summaries and commentary, we’ll include some general investment philosophy and strategy talk.

But for the most part, the site will be a database for our own research notes that Matt and I can use as a way of organizing information, research, links to articles on companies we follow, brief thoughts on company developments, and lots of other things.

No Change at BaseHitInvesting.com 

The main site—Base Hit Investing—will continue providing content on investment thoughts. The Members Site will be more of an inside look at our research files, our real-time thinking, and scratch notes (i.e. notes that we write in our own personal investment journals as we are in the midst of conducting research on stocks). The Members Site will also discuss our positions and investment decisions, etc… basically our investment journals made public. We decided to put it behind a paywall for a few reasons:

  1. Writing helps improve the investment process—and having a subscriber base (even a small one) gives us not just a platform but an obligation to write high-quality, thought-clarifying work—which is a precursor to an improved investment process.
  2. We like the idea of sharing research and scratch notes. I think it helps clarify my thought process, as I’ve mentioned before.
  3. We like the idea of having a database of research that we can use to look back on.
  4. Certainly, like any good capitalist, we don’t mind reaping some rewards on the content we produce if anyone finds value in it.

One ground rule: My investment management firm (Saber Capital Management, LLC) and Matt’s investment firm (The Sova Group, LLC) will always be our first priority when it comes to investment ideas. Most of the stocks that we buy have plenty of liquidity, but in the rare cases where they don’t, we will either buy first before commenting anything, or reserve the right not to mention the stock at all. But in almost all cases, sharing ideas—especially with a relatively small group of potential subscribers—will not hurt our own buying ability nor those of our readers.

That said, we have both found that writing in public has helped our investment process, and has improved our skills as investors. So for us, it’s a win/win. Writing helps us become better investors, which benefits our clients who we manage capital for. Hopefully, by offering more insight into our investment process, serious-minded investors who choose to participate will also benefit.

A Quick Word on Matt Brice

I am lucky to know a number of really outstanding investors (many of them off-the-radar small investors with very bright futures ahead). Matt is at the top of this list in my view. He is one of the most independent thinkers I am aware of. He runs a strategy that is straightforward and logical, but he is one of the rare investors who truly does concentrate on his best ideas, a “punch card” approach that has worked out tremendously well for him thus far.

I am familiar with each major investment Matt has made, and in my opinion his returns have been achieved without taking on excess risk, at least not by my definition (risk being the chance of losing permanent capital). Matt has achieved his record by owning quality investments, as well as investing in a few opportunistic special situations, but one of the best qualities of his portfolio management is his ability to truly focus on his best ideas, owning just a handful of stocks at a time.

Matt is a close friend. We talk frequently about investing ideas that we are looking at and companies that we are reading about. We use each other as sounding boards for our research, which helps us gain honest, unbiased feedback. As Buffett has said, it helps to have a sounding board, and I’ve found it to be very valuable, especially when the sounding board isn’t afraid to tell you where you’re wrong.

Feel free to contact Matt at matt@thesovagroup.com. Also follow him on twitter: @thesovagroup.

Our Research

So what we thought we’d do is basically begin to share some of our research with our readers who are interested.

If this is something you’re interested in, click here to subscribe or to see more details on what we’re offering. Also: we are making it real simple so that I don’t have to spend any back office time worrying about this (again, we have a business to run which is first priority and time is valuable).

So in light of this, the subscription will be a yearly subscription with no prorations or refunds. You can simply buy the access to the site for $500 per year, or $50 per month. There will be no trials or refunds, as that alleviates a lot of back office headaches on our end.

The objective here is not really to maximize subscribers, although we’d love to get some subscribers! The idea here is to put together a database of information, share it with those who want to read or participate, and hopefully improve our collective investment skills.

Check it out if you’d like. If not, keep reading the main blog! And as always, thanks for reading!


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.


John Hempton, who runs a hedge fund and writes the blog called Bronte Capital, wrote a really interesting post over the weekend on investment philosophy. He basically calls out the majority of the professional money management community for cloning Buffett in word, but not in deed. His main point: many Buffett followers talk about the “punch card” approach to investing, but very few people actually implement this approach.

Here is Buffett explaining the Punch Card philosophy:

“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”

It’s hard to describe how important and valuable this simple concept is. It’s one that I try to focus on, and try to get better at implementing each year.

But Hempton brings up a good point: lots of people talk about it, but very few people actually act this way. His reasoning for why people don’t follow such a sound approach is that it is hard to sell to clients. If you bought one stock every year or two, and you have a portfolio of say 7 or 8 stocks at a time, it may appear to clients (who see hardly any activity in their portfolios for months, sometimes years at a time) that you might not be working all that hard.

Trading activity has a way of making clients think that work is actually getting done. However, trading activity is almost always inversely correlated with investment performance. The client would be better off with the manager who charged his or her fee for selecting the punch card investments and then just sitting and waiting.

Bias Toward Activity

But human nature is difficult to overcome, and this type of an approach is difficult to implement. There are a few: Norbert Lou (who fittingly runs a fund named Punch Card) has built an outstanding track record of beating the market handily while making very few investments (his current portfolio consists of just three stocks and he makes very few new investments).

Hempton mentions that even Buffett’s two portfolio managers (Todd Combs and Ted Weschler) don’t follow a true punch card approach. I don’t know about Combs, but Hempton is wrong on Weschler I think, who is known for owning very concentrated positions in very few stocks and holding them for years (he compounded money at around 25% annually for 12 years in his fund before closing it to go work for Buffett, and the majority of his returns came from just a few positions that he held the entire life of the fund).

In fact, the majority of Weschler’s performance can be traced to two large investments that he owned throughout the life of his fund: DaVita and WR Grace. You could argue that those two investments were in large part responsible for his landing of a position at Berkshire. According to this article, he still holds a large personal stake in WR Grace (and what must be a massive personal deferred tax liability of something close to $100 million—he bought the stock for $2 in the early 2000’s).

So there are a few out there who walk the walk. But largely, I think Hempton is exactly right that most managers are biased toward activity. I also think many managers might not even consciously realize this bias. They intuitively want to convey to their clients that they are working hard, and one of the only ways to measure work progress (from the perspective of the client) is by looking at activity within the portfolio.

Some investment managers fear their clients think like this:

  • Lots of activity: the manager must be busy looking at lots of ideas
  • No change in the portfolio since last quarter: what has this guy been doing for three months? And why am I paying him?

Also, during a period of underwhelming performance, it can be difficult to stick with this approach. As Hempton says, these times can be extremely productive from a learning point of view:

But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like

a) I read 57 books

b) I read about 200 sets of financial accounts

c) I talked to about 70 management teams and 

d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada 

This is such a great point. That type of workload will produce measurable results at some point in the future, but it won’t show up in this quarter’s statement that clients receive.

Just because there isn’t a lot (or any) activity in the portfolio doesn’t mean there isn’t a lot of activity going on in the research/learning department. I try and focus on getting better each day, regardless of whether I’m buying or selling anything. And in fact, the days I feel I’ve improved the most as an investor are usually the days where I am away from my computer screen deep in thought, reading something useful, or having productive conversations with someone that knows more about a particular business than I do.

Fortunately, I happen to have great clients who don’t expect activity from me, so I don’t feel any pressure to “come up with new ideas”. Instead, I can conduct my research efforts each and every day, and wait for opportunities. That said, I can improve on focusing more on my best ideas, and I try each year to get better at this.

The Concept Matters

Let me say that the concept is what is important here, not the actual number of punches. Buffett selected 20 as an example. Obviously, Buffett has made hundreds of investments over the years. He once said at an annual meeting that his partnership (from 1956-1969) made somewhere around 400 investments in various stocks. But he also said that the vast majority of those investments were small investments that didn’t have a significant net benefit to his returns. The vast majority of the money he made in his partnership was made from a handful of well-selected investments that he made a large portion of his portfolio (the famous example of course being American Express in the early 60’s, when he put 40% of his assets into that stock).

The key for Buffett was not his batting average, but his slugging percentage. He hit a lot of home runs in the stocks that he took big positions in. And even in the 70’s and 80’s when he was running a much larger portfolio, his best ideas made up a sizable portion of his portfolio. A quick glance at the equity portfolio from 1977 shows 24% of the assets in GEICO and another 18% in Washington Post. 2/3rds of his portfolio was concentrated in five stocks. By that point in his career, he was fully implementing the punch card approach, probably in large part because of his review of his partnership where he realized only a few big ideas were responsible for the entire performance record.

But again, there is no magic number that should be focused on. I think the concept is what is the key: there aren’t that many great investment ideas, and it’s crazy to think that you can find great ideas every day, week, month, or even year. Great ideas are rare, should be patiently waited on, and should be capitalized on when they come.

Easy to say, hard to do—especially when there is a built-in bias toward activity.

To Sum It Up

I really liked Hempton’s introspective review of his own investment philosophy, along with his honest observations. The strange thing is that he seems to imply that the punch card approach is the most sound, but yet he himself doesn’t practice it. This confounds me a bit. Either he hasn’t been able to shake the same bias he talks about (in his view it’s a very tough sell to clients), or maybe he thinks he can build a bigger business (more AUM) if he implements a more conventional long/short hedge fund strategy. I’m just completely guessing at his reasoning. Maybe I’m wrong and he doesn’t think the punch card approach is best.

But I think recognizing the “over-activity” bias is most of the battle—if you understand that you, as an investment manager, are going to be prone to activity and over-trading in an effort to justify your existence, then you at least have a chance to guard against it. It’s those who “don’t know that they don’t know” are the ones who don’t have a chance. Hempton clearly isn’t in the latter camp. He knows that he (like most humans) might be prone to this bias, so you’d think he would choose to guard against it and implement the better approach.

Either way, it was an interesting commentary, and one that I really agree with. Practicing a portfolio management strategy that involves very few (and very large) investments in high-quality companies at very infrequent junctures is a great approach, but one that can be viewed as unconventional, and thus difficult to practice in real life. I hope and plan to keep improving on this, one day at a time.


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

I thought I’d put up a quick post with a couple articles I’m reading this weekend. But first, I wanted to mention to readers that I’ll be speaking at the MicroCap Conference in Philadelphia on October 24th. It should be a fun event with both investing strategy discussions as well as opportunities to talk with management teams of small companies about their businesses. Check out their site for more details or to register for the event. If anyone is attending and would like to meet up, feel free to contact me.

Weekend Reading

I often get asked what I read on a regular basis. At some point, I’ll put together a list, but for now, this list covers lots of ground, and overlaps with a good amount of what I read as well. This list was put together by my friend Connor Leonard, who manages the equity portfolio for IMC, a holding company that owns stocks and wholly-owned businesses. Connor also has written a couple excellent guest posts here on BHI. This is an AP-style ranking of Connor’s top reading material:


The Economist ranks number 18 on his list, just behind Women’s Wear Daily (which to date remains unranked on my Top 25). I tend to read the Economist on the weekend, as it usually contains a number of articles and news I find interesting, but these articles often get pushed to the back burner during the week.

Here are a few that I thought were worth reading this weekend from the Economist:

Still Ringing Bells–Slowing Growth and Less Innovation Do Not Spell the End of an Era

According to one research shop’s estimates, the global smartphone market will be about a $350 billion market this year. It is maturing, especially in developed countries, which was a primary reason for Apple’s stagnating stock price earlier this year. However, I agree with the author’s main point in this piece. The smartphone generally, and Apple in particular, have a very bright future (despite the saturation level).

My thought that I’ll add is that while innovation and technological shifts will keep occurring, Apple will continue to be a primary conduit from which that technology finds its way to the consumer. Apple sells hardware and software, but it is first and foremost a brand. Regardless of what widget it produces going forward, the brand remains one of the most valuable in the world. (And while other widgets will become popular, the iPhone isn’t going anywhere).

The REIT Stuff–Explaining the Boom in Property-based Investment Trusts

I think the residential housing market in the US is very strong, and with low inventories, low interest rates, still below average new builds, and the largest generation in history (the millenials) still largely preferring to rent (this will change as they get married, get dogs, get kids, get minivans, etc…), there are some tailwinds to that asset class.

I don’t feel as good about some of the commercial property sectors, as capital has been flowing into that asset class at a very high rate over the past few years:

“This year their market capitalisation passed $1 trillion, or 4% of the American total, close to the size of the utilities sector. They have been performing well, beating the market in 2014, 2015 and so far this year, when they have generated a return of 18.1%, and are trading at an average multiple of 23 times earnings, compared with 17 times for the S&P 500 index as a whole. In a mark of their new prominence, this month S&P and MSCI, another index provider, classified real estate as a distinct sector.”

Retail investors love these stocks for their dividends, and the sponsors love to issue those retail investors new shares, as their incentives often are aligned with “assets under management” (the more debt and equity capital they issue, the more they get paid). All REITs shouldn’t be painted with this brush, but the demand for dividend income from mom and pop investors who can’t find comparable interest rates for their savings have driven a large amount of demand for these securities. Those capital flows mean more demand for the underlying real estate, which has driven cap rates (a property’s cash flow divided by its purchase price) toward all-time lows. This, along with the high management fees, should be heavily considered when considering investing in these stocks, which own cyclical assets.

Prison Breakthrough

An interesting piece about the Nash Equilibrium, a theory which is best illustrated by the famous “prisoner’s dilemma” (which is described in the piece). Nash was a mathematical genius whose life was the subject of the movie A Beautiful Mind, and his contributions to mathematics and the subject of game theory won him a Nobel Prize. The Nash Equilibrium has practical implications for the business world:

“From auctions to labour markets, the Nash equilibrium gave the dismal science a way to make real-world predictions based on information about each person’s incentives…

“…Nash’s idea had antecedents. In 1838 August Cournot, a French economist, theorised that in a market with only two competing companies, each would see the disadvantages of pursuing market share by boosting output, in the form of lower prices and thinner profit margins. Unwittingly, Cournot had stumbled across an example of a Nash equilibrium. It made sense for each firm to set production levels based on the strategy of its competitor; consumers, however, would end up with less stuff and higher prices than if full-blooded competition had prevailed.”

Charlie Munger once mentioned how perplexed he was at how one industry (such as cereal makers) would all coexist with sizable profit margins while another industry (such as airlines) relentlessly pursue market share, eroding profitability in the process. It seems that airlines pursue their own interests to the detriment of the entire industry, whereas cereal makers (at least at one time) for some reason found a Nash equilibrium.

A Few Other Articles from Other Publications:

Have a great weekend!

Disclosure: John Huber owns shares of Apple and Saber Capital Management, LLC manages accounts that own shares of Apple. 


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

I am not a big fan of going through specific “checklist” items one by one when evaluating an investment idea. I know this idea has gained enormous popularity in recent years, partly due to the good book The Checklist Manifesto, and partly popularized in value investing circles by Mohnish Pabrai.

I respect Mohnish a lot, and I think his idea of evaluating previous investment mistakes (both his own mistakes and especially the mistakes of other great investors) is an excellent exercise.

One investment mistake to study would be Pabrai’s own investment in Horsehead Holdings (ZINC). This investment would be a case study that maybe I’ll put together for a separate post sometime, as it’s one that I followed during the time he owned it. There are a few reasons why I always scratched my head at why he bought ZINC, and there are a few reasons why I think it ultimately didn’t work, but one thing I’ll point out is what Buffett said in his 2004 shareholder letter (thanks to my friend Saurabh Madaan who runs the Investor Talks at Google for pointing me to this passage):

“Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

“Our failure here illustrates the importance of a guideline—stay with simple propositions—that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for—if you’ll excuse an oxymoron—mono-linked chains.”

This sounds very similar to the problem that Horsehead Holdings (ZINC) had with its zinc facility in North Carolina. Without going into details, I think there were too many variables that needed to go right for ZINC to work out as an investment.

But let me just say that mistakes are part of investing. So many people are so quick to cast judgment on investors like Pabrai, David Einhorn, or Bill Ackman when they make big mistakes. I’m not apologizing for these investors, but I think that those who are criticizing these investors should look at their entire body of work to draw conclusions, not just one bad investment. These three are very good investors with outstanding long-term records that have vastly exceeded the S&P 500, and they should be judged on that record, not the underperformance of the past couple years.

But regardless of what you think of these investors, it helps to try and learn from their mistakes. I wrote a post on Valeant a while back, which is Ackman’s biggest error. I also looked at SunEdison, which was an Einhorn investment. It is infinitely easier in hindsight (the rearview mirror is always clear) to attribute reasons for why these investments didn’t work out, but nevertheless, I think it’s helpful to study these mistakes.

I don’t think a 100-point checklist would have been necessary to pass on any of these three investments (ZINC, VRX, or SunEdison). Two of the three companies were ultra-focused on growing revenue regardless of the return on capital associated with that growth, using the so-called “roll-up” approach. All three of these investments saw their losses dramatically accentuated by debt.

I think each of these investments hinged on a few key variables (in addition to debt), and I think rather than running through a generic “pre-flight” checklist, a better method is to have a few very broad checklist items, and then determine the key variables that really matter regarding the business in question.

What do I mean by “broad checklist items”? One general checklist that Buffett and Munger use:

  1. Do I understand the business?
  2. Is this a good business? (Competitive advantages, high returns on capital, etc…)
  3. Is management competent and ethical?
  4. Is the price attractive?

It doesn’t get much simpler than that, and I think this 4-point filter is a common denominator that could be used on just about every investment.

Obviously, there is a lot of thought and analysis that goes into answering those simple questions, and so there are sub-categories that might pop up.

Key Checklist/Concept #1

This isn’t really a checklist item. But it’s a takeaway I’ve had through my own experiences:

  • Whenever I find myself getting more attracted to the security than I am to the business, it’s often a good reason to pass

My mistakes have almost always come from investing in “cheap” stocks of subpar businesses. I’ve learned that I’m better off focusing on good businesses. This means missing certain opportunities, but for me, it also means reducing errors. Also, when it comes to managing other people’s money at Saber Capital Management, I don’t feel comfortable owning low-quality businesses, regardless of how attractive the valuation appears to be. I mentioned this on Twitter recently and it sparked some interesting discussions.

There are a number of investors who disagree with me on this point. Some investors make a lot of money buying crappy businesses that are beaten down to really cheap valuation levels. It’s possible to make excellent returns buying garbage that no one else wants and selling them when the extreme pessimism abates some. This is the approach that guys like Walter Schloss used to great success in the 1950’s-1970’s—the so-called “cigar butt” style of investing.

But I think one big difference between the cigar butts of yesteryear and the stocks that investors get attracted to today is the debt levels on the balance sheet. The cigar butts that I read being pitched today are often questionable businesses that are loaded with debt. If things turn around and the company survives, the equity can appreciate multiples from its current level. If not, the company goes bankrupt and the equity gets wiped out.

It’s possible to become very good at handicapping these types of situations, but it’s not my style of investing. I choose to pass on these overleveraged companies with minimal chances of success.

Low Probability, High Payoff Investment Ideas

This brings me to another point I want to make regarding estimating probabilities. I read investment pitches all the time that discuss the probability of various outcomes. This makes sense—Buffett himself has talked about assigning probabilities to various outcomes of an investment. And certain odds might tell you that even a low probability event can be a very good bet to take. For example, a bet that has a 25% chance of winning and pays out 10 to 1 is a very good bet. It is a low probability bet that has positive expectancy, and it’s a bet you should take every time.

But I generally pass on low-probability ideas for the following two reasons:

  1. Unlike cards or dice (or other games of chance where probability can be more or less accurately determined), business and investing are dynamic with ever-changing odds. Cards and dice are closed-systems with a finite set of possible outcomes. Business is fluid, and there are an infinite set of unpredictable events that can greatly impact the outcome. It’s unreasonable to assign rigid probabilities to these types of situations.
  2. Investors tend to overestimate the likelihood of success of low-probability events (to use the above example, an investor might assume a 25% odds of success and a 10 to 1 payoff; but in reality it’s just 10% odds with a 5 to 1 payoff. The investor might accurately describe all of the moving parts of the investment, and rightly understand that it is a low-probability event, but still be way off with his or her estimate of risk/reward and thus make a bad bet). It is too easy to arbitrarily assign overly optimistic probabilities to this type of investment in an effort to justify buying the stock.

A year or two ago I read numerous Dex Media write-ups (the company that published phone books), including one by Kyle Bass. DXM was an equity stub—a sliver of equity with a huge amount of debt on a dying business that was trying to make a transition to digital from print. All of the write-ups recognized the obvious struggles of the business, and all recognized that odds of success were too low. But I think those who bought the stock overestimated the odds of success and/or the amount of the potential payoff. One investor said the DXM payoff could be as high as 100-1. This reward could justify an investment even at a very low likelihood of success.

The Fannie Mae and Freddie Mac investment cases might be current examples of this type of low-probability, high-payoff type investment. Maybe these will work out, but I think many are overestimating the likelihood of success.

In my experience, it’s better to forego the low-probability investment ideas. They are too difficult to accurately judge, and they usually involve bad (or highly leveraged) businesses.

Key Checklist/Concept #2

Schloss invested in poor-quality businesses in many instances. How was he so successful? Schloss used a checklist of sorts, and the very last (but not least) item on his checklist was:

  • Be careful of leverage. It can go against you.

This seemingly oversimplified statement is really great advice. I think that while Schloss invested in businesses with subpar (or no) competitive advantages, he was able to do well because of his patience and his willingness to wait for the cycle to turn. Many of his investments were in capital intensive, cyclical businesses—but most of the companies he bought had clean balance sheets.

Today, our society is much more accepting of higher debt levels—both at the personal level and at the corporate level. Because of the availability of debt made possible in part through securitization, it is much easier for companies to gain access to credit than it was in the 1950’s. Most companies that Schloss would have looked at in his day are now saddled with debt in an attempt to improve their inherent low returns on equity through leverage. Schloss was satisfied with the low ROE’s, as he figured he wasn’t paying much for it, and eventually, the earning power would inevitably turn higher as the business cycle turned from bust back to boom.

The business cycle still has the same fluctuations of course, but leverage now magnifies the equity values. I see scores of oil and gas producers whose stocks have risen 500% or more since the February lows. Leverage has magnified the comeback in their equity values. It also would have been their death knell had oil prices not bounced in the nick of time.

Schloss said in a Forbes article in 1973—aptly titled “Making Money Out of Junk” that there are three things that can go in your favor when you buy cheap, out of favor companies:

  • Earnings turn around and the stock appreciates significantly
  • Someone buys control of the company (buyout)
  • The company begins buying its own stock

However, you need a clean balance sheet to put yourself in position to capitalize on a cyclical upturn and the corresponding rebound in earning power that could come with it.

Where the Puck is Going

Stanley Druckenmiller gave an excellent talk early last year where he mentioned one of the two key things his mentor taught him:

“Never, ever invest in the present. It doesn’t matter what a company is earning, (or) what they have earned. He taught me that you have to visualize the situation 18 months from now… Too many people tend to look at the present…”

Buffett has mentioned closing his eyes and visualizing where a company is 10 years from now, or being happy owning the stock if the exchange shut down for five years.

I don’t think it matters what the exact length of time is, but the point is that when you make an investment in a stock, you’re buying a piece of a business. When I look out to a certain point into the future, whether its 18 months or 5 years, I’d rather try to focus on a company that I think will be doing more business, have greater earning power, and be more valuable than it is today.


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

Someone I’m connected with on Linkedin sent me this old article from 1977 in the Wall Street Journal on Warren Buffett. I thought I’d share it here, along with a few highlights. It’s an article I haven’t seen previously. There isn’t much new here, but I thought it was quick read with a couple passages worth commenting on.

One thing I don’t recall Buffett ever describing were the pressures of money management that he felt while running his partnership. This is Buffett describing the relief he felt after closing his fund:

“I’m having a lot of fun because I’m only going into businesses that I find interesting and where I like the people running them, and their products,” Mr. Buffett says. “It’s a tremendous relief being out of money management. I’m not constantly thinking about business anymore. During the partnership my ego was on the line, and I was trying to lead the league in hitting every year.”

I think there are a couple things to note here. First, Buffett knew that his overall record was due to his skill as an investor. But I think he also knew that his individual yearly results, where he beat the market each and every year for 13 years, was very unlikely and almost certain not to be repeated (or continued if he kept his partnership open). He knew that over 5 year periods, he would beat the market handily. But he also knew that any given year was much more up for grabs.

If we compare the results of Charlie Munger and Walter Schloss (who also ran partnerships during the same time), all three produced fantastic records, but Munger and Schloss underperformed the market about 1 in every 3 years, despite beating the market overall by huge margins (see this post for details on their performance records).

So I think the unrealistic expectations that Buffett thought his investors were placing on him began to wear on him. It’s unlikely these investors would have been so demanding (after all, Buffett made them all rich), but I can understand—being in the money management business and actively managing money for clients—that there is pressure when it comes to other peoples’ money. You treat it with much more importance than you do your own capital. That said, I was surprised to hear Buffett say he was glad to be out. I personally couldn’t imagine wanting to do anything else.

But Buffett felt a relief after shutting his partnership, and in the early years, it almost sounded like a semi-retirement. This is ironic of course, because he now is a fiduciary on a much larger scale than he was in the 1960’s.

But ultra-competitive people have a hard time staying away from the game, and Buffett is certainly no exception.

Retail is a Tough Business

“Mr. Buffett has taken some lumps. Several years ago, for example, Berkshire Hathaway lost half of a $6 million investment in Vornado Inc., a discount retailing concern based in New Jersey. ‘The stock looked undervalued when I bought it, but I proved to be incredibly wrong about the discount department-store business,’ Mr. Buffett says. ‘It turned out that the industry was over-stored, and Vornado and the rest of the discounters were getting killed by competition from K mart stores.’”

What’s interesting is that this quote is as relevant now as it was in 1977. It’s the same game with different players. Macy’s, JC Penney’s, Kohl’s and other struggling department stores have replaced Vornado, and the competitor wreaking havoc is no longer K-mart, but Amazon.

But it’s also interesting that Buffett says, “The stock looked undervalued when I bought it.” It’s strangely reassuring to know that Buffett himself was tempted by mediocre businesses that looked cheap. And most retailers are mediocre businesses that look cheap.

Whenever I review my own investment mistakes, they almost always come from situations where I was attracted much more to the valuation than to the business. These are the so-called value-traps—catnip to most value investors, but very often poor choices as investment candidates. I’ve learned to steer clear.

The problem for many investors is that sometimes these so-called value traps work out. You’re able to buy them and sell them for a 50% gain. But a year or two later they are often trading at or below (often well below) your original purchase price. The investment looked smart based on the realized gain, but was it really being smart, or just fortunate timing?

Each investment situation is unique, but the general lesson from this particular passage is that retail, specifically discount department stores, is a very tough business. Your competitors are offering the same merchandise you are (for the most part), and Amazon can match or surpass you in terms of price, selection and convenience. This puts you between a rock and a hard place—either cede market share to Amazon or other competitors (which isn’t really an option because that means lower revenue to spread across a largely fixed cost base), or cut prices to compete for customers (which, unless your lower prices lead to faster inventory turns, will still lead to lower revenue on already thin margins).

For some store concepts, this operating leverage can be a positive driver of margin expansion, returns on capital and earnings growth, but when your store that was once a favorite with customers begins losing its luster, this leverage works in reverse. All along the way, competition is brutal.

As Buffett has said regarding the retail store he ran in Baltimore (paraphrasing), “If the guy across the street started offering a 15% weekend discount, we had no choice but to match that promotion.”

It’s a very difficult game. There will be some winners for sure, but there will be a lot of losers. And it’s hard to predict (other than maybe Amazon) who will win. Some will “win” for a period of time before losing (K-mart and Sears once dominated before getting disrupted by Wal-mart, which itself is now getting disrupted by Amazon, etc…)


“Wall Street sources close to Mr. Buffett say that his stock investments in the past few years have been largely dictated by his concern over inflation. David Gottesman, senior partner of the New York investment concern First Manhattan Corp says:

“Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. For example, Warren likens owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.”

I don’t think Gottesman’s reasoning is completely accurate here. I doubt Buffett necessarily was buying companies as an inflation hedge—although that was a byproduct of the types of investments he made. I think his preference for durable businesses with strong competitive positions and excess free cash flow would have been his preference regardless of whether the economy was experiencing high inflation, low inflation, or even deflation.

I am not suggesting Buffett didn’t consider inflation as a major factor (he did discuss inflation often in his letters as well as this famous piece in Fortune), but I don’t think he changed his investment preferences much, if at all, based on what inflation was doing.

Regardless, it was an interesting piece from the Wall Street Journal archives.


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

This is just a quick post on some interesting articles I read over the weekend as I caught up on some newspaper reading.

There were a couple recent pieces (one in the Economist and one in the NY Times) on WeChat, the Chinese messaging app that now boasts over 700 million users. WeChat is also generating a significant amount of revenue (unlike Facebook’s WhatsApp and Messenger apps that haven’t monetized their networks yet). WeChat is also estimated to be very profitable for its owner, Tencent Holdings, an online gaming and social media giant in China.

Here are a few notes as I read the two articles:

What is WeChat?

From the Economist piece:

Like most professionals on the mainland, her mother uses WeChat rather than e-mail to conduct much of her business. The app offers everything from free video calls and instant group chats to news updates and easy sharing of large multimedia files…

Yu Hui’s mother also uses her smartphone camera to scan the WeChat QR (quick response) codes of people she meets far more often these days than she exchanges business cards. Yu Hui’s father uses the app to shop online, to pay for goods at physical stores, settle utility bills and split dinner tabs with friends, just with a few taps. He can easily book and pay for taxis, dumpling deliveries, theatre tickets, hospital appointments and foreign holidays, all without ever leaving the WeChat universe.”

Here is a snapshot of the app compared to the two other huge messaging apps (both owned by Facebook):

WeChat Profile

Why/How was WeChat able to grow so quickly:

  • SMS messaging is costly in China. This is unlike the US where large telecoms bundled text messaging services with other basic phone services to make texting affordable.
  • In the US, this affordability of texting via your phone provider also meant that there wasn’t as much of a need for a separate dedicated messaging app. This is partly why messaging apps like Facebook’s Messenger or WhatsApp, while very popular in the US, aren’t completely ubiquitous like WeChat is in China. There are 700 million users despite there being “only” 600 million smartphone users in the country. Just about everyone uses WeChat in China.
  • The higher cost of text messages in China led to a gap that WeChat was able to fill. Users eager to text one another quickly led to mass adoption and a foundation for WeChat to provide other offerings to its suddenly vast network of users.
  • China consumers largely skipped right to smartphones—many never purchased a PC. The lack of experience using a desktop made it more natural for Chinese consumers to complete tasks on a mobile device that Americans and Europeans might still be using their PC’s for. Half of all online sales in China take place on a mobile device, versus roughly a third in the US.
  • The app ecosystem didn’t grab hold as much as it did in the US and Europe. Instead of smartphone users utilizing hundreds of apps that each perform unique functions, firms in China like Baidu, Alibaba, and Tencent have developed apps that can perform many different tasks (messaging, social media, games, mobile payments, ecommerce, videos) all within the same app.

Network effect

WeChat’s exponential growth in users has created a platform that has allowed the app to branch out into mobile payments and ecommerce, among other offerings. Consumers can make purchases directly from merchants (who are increasingly attracted to the vast potential customer base), with WeChat taking a cut on every transaction. As the number of users grows, so does the value proposition for potential merchants, advertisers, and developers (who can create their own apps inside of the WeChat universe).

The Economist summarizes the network effect:

“E-commerce is another driver of the business model. The firm earns fees when customers shop at one of the more than 10m merchants (including some celebrities) that have official accounts on the app. Once users attach their bank cards to WeChat’s wallet, they typically go on shopping sprees involving far more transactions per month than, for instance, Americans make on plastic. Three years ago, very few people bought things using WeChat but now roughly a third of its users are making regular e-commerce purchases directly through the app. A virtuous circle is operating: as more merchants and brands set up official accounts, it becomes a buzzier and more appealing bazaar.”

WeChat’s First-Mover Advantage

The more fragmented app ecosystem in the West will make it harder for any one messaging app (including WeChat) to build as powerful a network effect as WeChat has done in China. Western users already use many different apps for a variety of services, and so it will be difficult for any single app to achieve the winner-take-all status that WeChat was able to grab in China. But as the article summarizes, this also creates a moat for WeChat on its home turf:

“Nor is there much chance that Facebook could make a significant dent in WeChat’s dominance in China. The Silicon Valley darling enjoys incumbency and the network effect in many of its markets. That has sabotaged WeChat’s own efforts to expand abroad… But the same rule applies if Facebook enters China, which could happen this year or next. ‘We have the huge advantage of incumbency and local knowledge,’ says an executive at Tencent. ‘Weixin (the Chinese name for WeChat) is quite simply more of a super-app than Facebook.’”

Tencent’s Potential Crown Jewel?

The app that is there “at every point of your daily contact with the world, from morning until night” is a very valuable asset for its owner Tencent Holdings.

I haven’t spent any time looking at Tencent, but I did pick up the annual report this weekend and skim through it. Here are the numbers of for the past five years that I converted into USD at the current exchange rate as of today:

Tencent Income Statement

The company makes most of its revenues and earnings from online gaming, with advertising generating most of the rest of the revenue. WeChat’s revenue was an estimated $1.8 billion last year, which is a small piece of the pie at this point. Time will tell if the company is effective at monetizing the platform that it has built (which is needed to justify the stock’s current valuation), but it appears to be building a lot of momentum.

I had never looked at Tencent before, but I put it on a watch list to study more in depth. I’ve been wary of investing outside the US (which is my own geographical circle of competence)—especially in a company that isn’t listed on an American exchange. But investing is a game of connecting the dots, as Ted Weschler said recently, and reading articles about growing businesses like this adds a few new dots to the mix.

Here are some other pieces to help connect the dots:

Some other articles that discuss WeChat or the business of apps in general (some are old, but I thought still provided helpful context):


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com. 

This post is the second guest post by my friend Connor Leonard, in what I hope to be a somewhat regular “column” here at BHI (by regular, I mean as often as Connor decides to put the proverbial pen to paper and share his insights with us). Based on the quality of his work, he’s welcome back anytime. Connor and I live in Raleigh, NC, and get together regularly to share investment ideas. I encourage you to reach out to us if you’d like to meet up sometime for coffee. My contact info is on this site, and his contact info can be found at the bottom of this post.

What follows is what I’ll call “Part Two” to his excellent post on Reinvestment Moats vs. “Legacy Moats”.

Here is Connor’s post:

Reinvestment Moat Follow Up

A couple of months ago John invited me to contribute a guest post to Base Hit investing (link) where I discussed the difference between Legacy Moats and Reinvestment Moats. While I encourage you to read the post for the full explanation, below is a quick summary:

Low/No Moat: The typical business you encounter during the day likely falls into this bucket, such as your average convenience store or insurance agency. These are perfectly fine businesses and likely provide employment within the community and a solid product or service to customers. However without a sustainable competitive edge it will be difficult to earn exceptional returns as an investor owning a Low/No Moat business unless you time the entry and exit well. Specifically the game plan has to be to buy at a discount (say $.50 on the dollar) and exit at around fair value ($.95 – $1.00) in a relatively short amount of time[i].

Legacy Moat – Returning Capital: These businesses have an entrenched position within current markets that enable strong and consistent profitability relative to the prior invested capital. However there are few opportunities to deploy incremental capital at similarly high rates, so the management team decides to distribute the majority of the earnings back to owners at the end of each year. This is a prudent move by the management team, and essentially turns the company into a high yield bond. Many “wide moat” companies such as Procter & Gamble and Hershey’s successfully follow this strategy, distributing 80%+ of annual earnings out as dividends. While this investment profile is adequate for many, if you are aiming to compound capital at 15% – 20% rates it likely will not come from owning this kind of business over a long stretch.

Legacy Moat – “Outsider” Management: Here you have a business with all of the characteristics of a Legacy Moat, but the management team decides to retain all of the capital and deploy it into new businesses through a focused M&A program. The home office effectively serves as an internal private equity fund, using the permanent capital supplied by the operating companies to fund a disciplined acquisition effort. When the right businesses are paired with an exceptional capital allocator, the result can be remarkable compounding of shareholder capital such as Berkshire Hathaway (Buffett), Tele-Communications Inc. (Malone), and Constellation Software (Leonard).

Reinvestment Moat: This is the rare company that has all of the benefits of a Legacy Moat along with ample opportunities to deploy incremental capital at high rates within the current business. In my opinion this business is superior to the “Legacy Moat – Outsider Management” because it removes the variable of capital allocation: at the end of each year the profits are simply plowed right back into growing the existing business. This is the purest form of a “compounding machine” and when combined with a long reinvestment runway the result can be a career defining investment. Examples listed in my last post include GEICO, Walmart, and Amazon.

Following my initial write-up I noticed some questions and discussion around a fourth type of business: companies that can grow revenue and earnings without requiring additional capital. In this follow up post I thought it would be useful to discuss the characteristics of these “Capital-Light Compounders”, the playbook for how they should be run, and some current examples. Consider it an addendum to the original write up:

Capital-Light Compounders

As an investor I’m constantly looking for businesses that I believe can increase intrinsic value per share at a high rate over a long period of time. As John outlined in a recent post (link), a simple formula for estimating the rate of increase in intrinsic value is:

Connor Clip 1 Revised

This makes sense, if a company keeps 50% of earnings and reinvests that capital at a 20% rate, over time that should add about 10% to annual earnings power, thereby increasing intrinsic value by 10%. However there are a handful of companies that defy this logic. These “Capital-Light Compounders” are able to increase earnings power with zero or even negative capital employed. How do these companies accomplish this feat?

There are a couple of common characteristics in almost all Capital-Light Compounders, specifically negative working capital, low fixed assets, and real pricing power.

Negative Working Capital:

To determine the working capital structure of a company examine the balance sheet over the last few years and do some quick math to calculate the typical levels:

Connor Clip 2

Note: For this calculation I advocate using round numbers and rough estimates for excess cash. Working capital is dynamic and it is not necessary to calculate a precise number down to the last dollar to arrive at a general conclusion[ii].

A typical business will have a positive number for this calculation, however certain companies will be consistently negative – these are the ones we are looking for. Negative working capital often means the customers are paying the company cash up front for goods or services that will be delivered at a later time. This is a powerful concept for a growing company, as the customers are essentially financing the growth through pre-payments. Best of all the interest rate on this financing is 0%, pretty tough to beat. It is common to see negative working capital in subscription-based business models where customers pay up for recurring service or access. Some examples include SiriusXM, Verisk Analytics, and Atlassian. Because revenue is recognized when the service is performed, which is after the cash comes in, these businesses typically have operating cash flow that exceeds net income.

Low Fixed Assets:

The second characteristic of a Capital-Light Compounder is low fixed asset intensity, which can be analyzed by comparing net PP&E and/or capital expenditures to annual sales. If a typical manufacturing business wants to grow it will require significant capital investments in new factories, machinery, and trucks. Instead we are looking for companies that make money based off intangible assets such as brand name, intellectual property, or developed technology. A classic example is a franchisor, such as Dairy Queen, Burger King, or Winmark. In this business model the franchisor collects a royalty from franchisees in exchange for the use of the brand name, business plan, recipes, and other proprietary assets. The overall system grows as franchisees supply the capital to build new locations, enabling the franchisor to increase revenue and earnings without deploying additional capital. The key factor to focus on when analyzing a franchisor is the cash-on-cash returns the franchisees earn from building new locations. If this metric remains strong, the brand should have a long runway of unit growth ahead.

Real Pricing Power:

Finally if the business provides a product or service that is differentiated, has high switching costs, and is critical to customers it may be able to consistently raise prices at levels exceeding inflation. This is the simplest way to grow earnings without additional capital because the flow-through margins on price increases should be extraordinarily high. Companies such as CapitalIQ and See’s Candy have long histories of raising prices at or above inflationary rates, and Buffett considers this one of the most important variables when analyzing a business:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

So if you run a Capital Light Compounder that is fortunate to have all of these characteristics, what is the playbook for maximizing intrinsic value per share? One option would be to allocate the excess capital into mergers and acquisitions in an effort to grow earnings power. The issue here is that if you start with an exceptional business like Visa or Moody’s, it’s almost certain that the acquired business is inferior and will dilute the overall quality. Additionally, acquisitions can end up becoming a distraction that take management’s time and focus away from the core “crown jewel” business. The classic example of this pitfall is Coca-Cola in the 1980’s, which allocated proceeds from the core business into acquiring Columbia Studios before refocusing a few years later.

Instead my preference would be for management to undertake a systematic share buyback program, what Charlie Munger would affectionately label as “cannibalizing” their own share count over time. Instead of acquiring a new business and the risks associated with that strategy, the management should instead direct M&A funds towards acquiring more of the exceptional business that the shareholders already own. Aggressive share shrinkers such as NVR, Inc., AutoZone, and DirecTV successfully reduced share count by over 50% within ten year stretches.

This strategy creates a “double dip” for shareholders that can greatly enhance the compounding of intrinsic value per share. Imagine you own shares in a Capital-Light Compounder that is about to begin a decade long run of share cannibalization. Over that stretch, the business may increase earnings power at 10% per year, which would typically result in a ~10% return to an owner if the valuation multiples were held constant. However in this case additional capital was not required to grow, so instead 100% of earnings power was available for ongoing share repurchases, raising the IRR on the investment to 17.9% (refer to calculations below). This formula is how certain companies can turn solid growth into exceptional shareholder returns over long stretches.

Connor Clip 3 Revised

Note: even the best Capital-Light Compounders require some annual capital expenditures, so the amount of earnings allocated to share repurchases will probably be less than 100%. This example is more for illustrative purposes.

Are “Capital-Light Compounders” superior businesses to “Reinvestment Moats”? My current thought is that in an inflationary environment the Capital-Light Compounder is the preference because the lack of physical assets enables revenues to increase without the corresponding need for heavy capital expenditures at inflated rates. It is an interesting topic to debate, one which certain investors have weighed in on overtime:

“The best business is a royalty on the growth of others, requiring little capital itself.” – Warren Buffett[iii]

[i] Many great investment careers have been built on this method, I am not knocking it at all, it’s just a different approach from the one I focus on. I think the key to identify what approach works best for your personality and then be disciplined within that framework.
[ii] Calculating excess cash is more art than science. Some investors would advise you to remove all cash from this calculation, personally I believe you need a reasonable amount of “cash in the drawer” for a business to run.
[iii] From John Train’s The Money Masters – which has an excellent chapter on Buffett

Connor Leonard is the Public Securities Manager at Investors Management Corporation (IMC) where he runs a concentrated portfolio utilizing a value investing philosophy. IMC is a privately-held holding company based in Raleigh, NC and modeled after Berkshire Hathaway. IMC looks to partner with exceptional management teams and is focused on being a long-term owner of a family of companies. For more information visit www.investorsmanagement.com or reach Connor at cleonard@investorsmanagement.com, or on Twitter at @CataumetCap.

I recently made a list of a few shareholder letters I want to read, and one that I completed a few days ago was Credit Acceptance Corp (CACC). This post is not a comprehensive review of the business, as I just started reading about the company. But I thought some readers might be interested in some initial notes.

(I am thinking about putting more of these “scratch notes” up as posts. If this is interesting to readers, please let me know. Often times, I read about a company and don’t end up coming to a solid conclusion. I have many pages of notes on companies that I don’t ever discuss, simply because the information might not be actionable currently. But if these types of notes are worth reading, then I’ll begin putting up more of them.)

Credit Acceptance Corp makes used-car loans to subprime borrowers. CACC has a different model than most used-car lenders. Instead of the typical subprime auto-lending arrangement where the dealer originates the loan and the lender buys the loan at a slight discount, CACC partners with the dealer by paying an up-front “advance” and then splitting the cash flows with the dealer after CACC recoups the advance plus some profit. The advance typically covers the dealer’s COGS and provides a slight profit, and CACC has a low risk position as it gets 100% of the loan cash flow until its advance is paid back. What’s left over gets split between CACC and the dealer. The bottom line is that the dealer gets less money up front, but has more potential upside from the loan payments if the loan performs well.

The model works like this (these are just general assumptions and round numbers to illustrate their model): Let’s say a used-car dealer prices a car at $10,000. Let’s say the dealer paid $8,000 for that car. The dealer finds a buyer willing to pay $10,000, but the buyer doesn’t have $10,000 in cash, has terrible credit, and can’t find conventional financing. CACC is willing to write this loan (CACC accepts virtually 100% of their loans). The buyer might pay $2,000 down, and CACC might send an advance to the dealer of around $7,000. So the dealer gets $9,000 up-front ($2,000 from the buyer and $7,000 from CACC). The dealer now has no risk, since it has received $9,000 for a car that cost it $8,000, and although the profit might be lower than if it got the full $10,000 retail value in cash, the dealer can make more money if the loan performs well. The $8,000 loan might carry an interest rate of 25% for a 4 year term, which is about $265 per month.

As the payments begin coming in, CACC gets 100% of the cash flow from the loan ($265 per month) until it gets its $7,000 advance paid back plus some profit (usually around 130% of the advance rate). Once this threshold is hit, if the loan is still performing, CACC continues to service the loan for around a 20% servicing fee, and the dealer keeps the other 80% of the cash flow as long as the payments keep coming in.

CACC has perfected this model and has achieved significant growth over time by steadily signing up more and more dealers. The result is a compounding machine:


But the conditions are always competitive in this business, and currently, lending terms are very loose and competition is brutal. But CACC is the largest in this space, and seems to be able to perform fairly well in periods of high competition by:

  • Allowing volume per dealer to decline (fewer loans get originated at each dealer as CACC is willing to give up market share to competitors who are willing to provide loans at looser terms)
  • Growing the number of dealers it does business with (developing more partnerships with new dealers helps offset the decline of business that is done at each dealership)

So overall, CACC has been able to grow volume consistently in good markets and bad markets by adding dealers to its platform. The company allows market share to decline during periods of high competition, and then when the cycle hardens (money tightens up), CACC is able to take back some of that market share.

Adding New Dealers Gets Harder

The problem is that CACC is now much bigger, and growing the number of dealers to offset the declines in volume that occur during soft markets is much more difficult. The company only had 950 dealers in 2003, which was the beginning of the last cycle. By 2007, the company had roughly 3,000 dealers. Dealers provide the company with customers. The ability to triple your potential customer footprint is extremely valuable as it allows you to lose significant market share at the dealership level and still write profitable loans at high returns on capital. Indeed, the company saw the number of loans per dealer decline by a whopping 41% during the soft (competitive) market cycle between 2003-2007. But during this time, its 3-fold increase in the number of dealers enabled overall volume to increase and earnings per share went from $0.57 to $1.76.

The market tightened up in 2007 (a good thing for companies like CACC because while economic conditions are difficult, higher cost competitors go out of business which makes life much easier for the remaining players). With a dealer count that was three times as large as it was just four years before, CACC could now focus on writing profitable loans and growing volume per dealer (i.e. taking back market share it lost at the individual dealership level).

The results are outstanding for a company that can successfully execute this approach, and CACC saw earnings rise from $1.76 in 2007 to $7.07 in 2011 thanks to a combination of growing profits and excess free cash flow that was used to buy back shares.

However, the cycle has gotten much more difficult again—starting in 2011 and continuing to the current time. CACC—to its credit—has continued to fight off competition by adding new dealerships (it has doubled its dealer count since 2011). But each year this becomes harder—CACC now has a whopping 9,000 dealers on its platform (nearly a 10-fold increase from 2003).

Competition is extremely tough currently, with dealers having the pick of the litter when it comes to offering finance options to its customers. CACC proudly states in its annual report: We help change the lives of consumers who do not qualify for conventional automobile financing by helping them obtain quality transportation”. I think in the early years, this was true. Dealers could go to CACC for financing for its customers when no one else would lend money to that subprime borrower.

But CACC isn’t the only option currently, which means the terms CACC can demand are weaker. CACC used to write loans that were 24 months in the 1990’s. The average loan now has around a 50 month term. As competition heats up, dealers have more options as the third column in this table demonstrates:

CACC-Dealer Volume

CACC has grown mightily over the years, but since 2003 it has fought off a 50% decline in loans per dealer by dramatically growing the number of dealers it works with.

Can CACC Continue Compounding at the Same Rate?

The question for anyone looking at CACC at this level is whether the company can continue to perform well during increasingly competitive conditions. To produce attractive returns on invested capital going forward, the company needs one of two things to happen:

  • Conditions need to worsen (higher interest rates, tighter monetary conditions) which will cause weaker competitors to exit the industry and lower the capital available to borrowers
  • Absent better competitive conditions, CACC needs to be able to continue adding to its dealer count at a rate that more than offsets declines in loan volume per dealer

Thus far, the company has always been able to execute on the latter category. But it becomes harder and harder to move the needle as the company gets larger and larger. The company has 9,000 dealers and there are roughly 37,000 used-car dealerships in the US. So while growth is possible, a 10-fold increase in dealerships–which is what CACC has achieved since 2002–is no longer in the cards. I think the company will be much more dependent on the first category (competitive conditions) going forward, which unfortunately means they will be slightly less in control of their own destiny.

The hard part is trying to figure out when that cycle changes. And even when the cycle changes, I’m not sure that—short of a credit crisis—enough capital will leave to make life easy again for well-capitalized firms like CACC. Cycles will ebb and flow for sure, but there is a lot of data that points to how well auto loans performed during the credit crisis—which makes me think capital won’t flee the industry in a manner that many hope/expect.


The post is getting long, but I thought I’d briefly mention a few risks, which can be more thoroughly discussed in comments or another post.

One general risk is the regulatory risk as the CFPB has begun looking at subprime auto lenders. One related specific question I have asked myself while reading about CACC is this: why would the dealers agree to this model? Why would they accept a lower up-front cash payment (even with the potential added upside at the end of the loan term)? It doesn’t make a lot of sense to me. If you’re a dealer—why would you accept less cash up-front in the hopes that in 3 years you’ll begin to get some of that cash back from the dealer holdback (the amount that CACC splits with the dealer after it has been made whole)? You can likely maintain higher asset turnover and higher returns on capital by getting more cash up front and moving that money more quickly into new inventory than waiting 3-4 years for modest upside from interest payments.

I fear that there are two possible answers to why dealers participate in this structure. One reason could be because the dealers either can’t get this customer financing anywhere else (even from other subprime lenders–which means the customer is truly a bad credit risk by even subprime standards). The other possible reason is because dealers might be able to artificially inflate the price of the car above its fair market value–i.e. what a cash buyer or a buyer using traditional financing would pay for the car. If the car is only worth $12,000 but the dealer can get $14,000 by simply making sure the monthly payments are “affordable” (which is often the main point of concern for the typical subprime buyer), then the dealer can get an advance rate from CACC that is close enough to what the dealer would receive from one of the other traditional lenders or a cash buyer. This effectively gives the dealer nearly as much up front cash as well as the added kicker if the loan performs well. Meanwhile, the buyer overpays for a vehicle as a penalty for not being able to obtain traditional financing. That said, I don’t have evidence this is the case–but I am just posing these questions that crossed my mind as I read the 10-K, as I tried to put myself in the shoes of the dealers who willingly accept lower cash payments despite a seemingly unlimited array of options from other lenders.

One other aspect of this business that makes me uncomfortable is the very high default rates that exist across the subprime auto business. It is very hard to look through CACC’s annual report and get a clear answer on what the default rates really are, but they only collect about 67% of the overall loan values, which implies the average borrower quits paying 2/3rds of the way through the loan (it’s possible this number isn’t as bad as it appears since some cars might get sold, and the overall “loan value” includes projected principal and interest, but regardless–defaults rates are sky high). Looking at competitors like CRMT and NICK (which use more conventional provisioning methods)–reserves for credit losses are currently between 25-30% of revenues, and have risen dramatically in the previous five years or so.

Counteracting these risks are the fact that insiders have huge stakes in this company, and it does appear to be very well-managed business over a long period of time.

Brief Word on Valuation

It’s interesting how much higher CACC is valued than smaller (weaker competitors)—Nicholas Financial (NICK) is one I’ve followed casually to use one example. CACC is currently valued around $4 billion. For that, you get around $3.3 billion in net receivables and $1 billion of equity. NICK is roughly 10% of that size ($311 million receivables and $102 million equity), but has a market value of just $80 million. In other words, NICK has a price to book (P/B) ratio of 0.8 and CACC is priced at 4.0 P/B, or five times as expensive. Both have similar levels of debt relative to equity as well.

CACC gets much better returns on its equity than NICK, and so its valuation relative to earning power is only twice that of NICK’s (14 P/E at CACC vs 7 P/E at NICK). But I think given that they are competing for the same general customer, there is a pretty hefty premium baked into CACC’s shares.

I think CACC will likely do well regardless of how long these soft conditions last. And when the cycle hardens up, CACC has a large amount of dry powder available to cash and credit commitments that will allow it to fully take advantage of better lending conditions. But given the size of the company and the increased level of difficulty that they’ll face growing their footprint, I’m not necessarily sold on the current valuation in the stock, especially given the risks in a business like subprime auto lending.

To Sum It Up

They’ve done an impressive job of growing through the cycle by willingly ceding market share to preserve profits at the dealership level during competitive markets and offsetting this by increasing the number of dealers it works with. Now that they have over 9,000 dealers, it’s impossible to achieve the same level of growth going forward, and so the high returns on equity will be much more dependent on the level of profitability they can get with each loan, which will likely require some help from the competitive landscape. I think CACC remains quite profitable, but I don’t think they’ll see anywhere near the same rate of earning-power compounding going forward.


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com. 


I came across a case study that discusses Dempster Mill recently. I thought I’d post a brief summary of some notes I jotted down while reading it. Dempster Mill is a company that Buffett bought in the early 1960’s when operating his partnership.

The company manufactured farm equipment, specifically windmills and water irrigation systems. It was a difficult business because the farm equipment it made was not much different than its competitors’ products, and because of these commodity-like economics, the business produced low returns on capital, and in fact struggled to break even. But despite its poor earning power, Buffett bought the stock because of the discount to its net tangible assets–a classic cigar butt.

Here is Buffett’s introduction of Dempster Mill from his 1961 letter to partners:

“Dempster is a manufacturer of farm implements and water systems with sales in 1961 of about $9 million. Operations have produced only nominal profits in relation to invested capital during recent years. This reflected a poor management situation, along with a fairly tough industry situation. Presently, consolidated net worth (book value) is about $4.5 million, or $75 per share, consolidated working capital about $50 per share, and at yearend we valued our interest at $35 per share…”

Buffett bought this originally as a generally undervalued stock—one that he bought because it was cheap and expected to sell out at a profit at some future date. Indeed it was cheap: Buffett paid around $28 for a stock with $50 of working capital and $75 of book value. However, the stock remained cheap as the business struggled, and Buffett began buying more of it—eventually owning 70% of the company. The position represented 21% of his portfolio.

What’s interesting is that Buffett took control of the company, and expected two possible ways to profit from this investment: the company could improve its operations and achieve a higher valuation in the market, or the value of the assets could be monetized (through liquidation or asset-sales).

“Certainly, if even moderate earning power can be restored, a high valuation will be justified, and even if it cannot, Dempster should work out at a high figure.”

Buffett and Charlie Munger worked together on this investment—and they brought in their own manager in hopes of restoring the company to profitability.

The case study provides the complete story of this investment, or just read the 1961-1963 partnership letters for complete details. Snowball and The Making of An American Capitalist provide more commentary from Buffett and Munger as well.

Dempster Mill Summary

Here are some notes I jotted down as I read the case study and reread the old partnership letter:

  • Buffett bought the stock of Dempster Mill extremely cheap (as low as 25% of book value)
  • He was very patient, buying it in dribs and drabs over 5 years—from 1956 until 1961
  • At first he was content to buy a cheap stock, but as he bought a larger stake in the company, he began taking more control of the operations
  • Management paid lip service to fixing operations and cutting bloated costs
  • Eventually, Buffett owned 70% of this business with low earning power and bleak prospects. He needed to turn it around in order to either sell the company or improve earnings.
  • Charlie Munger, who wasn’t particularly fond of poor businesses like Dempster, recommended hiring Harry Bottle.
  • Bottle was surprisingly able to turn the company around. He cut costs and liquidated assets. Bottle sold down excess inventory so Buffett could use the proceeds to invest in stocks for Dempster’s account. Bottle laid off workers, closed unprofitable branch locations. He even was able to improve business operations which led to modest sales growth, and thanks to his focus on keeping costs under control, profitability improved.
  • Bottle helped Dempster gain profitability and use up its tax losses, which eventually led Buffett to want to either fold Dempster’s business into BPL partnership (to avoid the corporate double taxation) or to sell the company outright.
  • The company ended up getting sold around book value for $80 per share, a nice increase from the $15-$30 per share where Buffett was buying his shares at years earlier.

My Own Comments on the Dempster Mill Investment

The investment was a big success for Buffett’s partnerships (BPL). I think the key though was not the bargain price that Buffett paid for the shares, but the fact that Harry Bottle was able to turn the company around by stabilizing sales, cutting unnecessary costs, and improving profitability. If Bottle didn’t come along, the company’s management likely would have continued down the same path, which would have led to mediocre or poor operating results, which likely wouldn’t have resulted in anywhere near the success that BPL had on this investment.

When it was all said and done, BPL had over 20% of the partnership invested in Dempster, and the stock went up nearly 3-fold from the original purchase price.

But if it weren’t for the shrewd strategies of Harry Bottle, this could have been a mediocre investment at best, and at worst, in Buffett’s postmortem words:

“If Dempster had gone down, my life and fortunes would have been a lot different from that time forward.”

The moral of the story is that Buffett invested in a cigar butt that went nowhere for years until he was able to gain control and install his own manager—who had a focus on essentially liquidating the company. If it weren’t for Bottle, the company would have almost certainly continued to destroy value.

Unlike BPL’s purchase of American Express or Disney whose intrinsic values were increasing as time went on, (and whose stock prices responded accordingly—the  former went up 3x for BPL and the latter gained about 50% the year after Buffett bought it), Dempster was eroding its intrinsic value each year that it continued to exist. The best result is a quick sale or liquidation for these types of investments.

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com