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…)

Inflation

“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:

CACC-Compounding

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.

Risks

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

I thought I’d put up a quick post with an interesting chart that might provide some food for thought. Considering the volatility in the past few days that was created by the surprising results of the “Brexit” referendum where the U.K. voted to leave the European Union, I thought this might be a timely topic to think about. In the past I’ve discussed how sometimes even the largest cap stocks can get mispriced from time to time (see here and here).

I was preparing a slide presentation recently for a friend of mine at Google who is in charge of a value investing club for Google employees (and also the person who organizes the outstanding Investor Talks at Google series). One of the topics I was commenting on was the idea that even large cap stocks can get significantly mispriced from time to time. Some people refer to this concept as “Time Arbitrage”—basically being able to look out 2-3 years when much of the market is focused on the next quarter or two. I think this behavioral concept is the largest advantage that individual investors have—should they choose to capitalize on it.

Large caps might often seem fairly priced (or “efficiently” priced). But taking a look at the fluctuations of the past year (which saw a 10%+ correction, but one that is not at all uncommon by historical standards), it is clear that there are potential opportunities that are served up by Mr. Market among even the biggest of all mega-caps.

It is interesting to note that as I updated this chart from the one I used in my presentation just two months ago, the top company on the list has seen its market cap decrease by roughly $100 billion and three other companies have seen their market values fluctuate by $30 billion or more—all in just two months.

Here is a chart of the top 10 largest companies in the S&P 500, and the percentage change as measured by its 52 week high vs. its 52 week low:

52 week fluctuations June 2016

So the average gap between the yearly high and low price is nearly 50% for these ten mega-cap companies, or an average yearly change in market value of $130 billion. Pretty remarkable.

8 of the top 10 companies saw their market values fluctuate by $100 billion or more. Many of these businesses have very stable earning power with mature, slow-changing business models. It is remarkable to me that a company like Johnson and Johnson can see a $100 billion fluctuation in value between its 52 week high and its 52 week low. Of course, these fluctuations are often correspond very closely to the fluctuations in the overall market, but the fact is that there is almost no chance that a company like JNJ is worth $225 billion in one month, and a few months later is worth $325 billion. There isn’t that much that changes in the course of a few months in most companies of this size.

It should be said that this doesn’t mean that one of these two prices represents a big discount to fair value, it just means that if you sift through even the largest index of stocks (the S&P 500), there are bound to be some fantastic bargains from time to time—even in the largest companies in the world.

As I mentioned in the post on Einhorn’s book, I can categorize market inefficiencies that come from two main sources (there are others, but these are the primary two sources in my experience): Disgust and Neglect.

Companies that get neglected (or haven’t been followed in the first place) are where many opportunities come from. These are often the small or micro-cap companies that can be discovered by diligently turning over rocks.

The large cap companies are not neglected by any means, but they can occasionally become just as mispriced through disgust, or pessimism. The ability to adopt a frame of mind that focuses on a longer time frame (and the variables that impact the outcome over such time frame) is what is required to capitalize on this category of mispricing.

There are obviously opportunities in smaller companies that are several magnitudes greater than in large caps, but my general point in displaying the largest companies is really just to demonstrate that even the stocks of the biggest companies can get mispriced by a not-so-insignificant degree at times.


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

“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.”Warren Buffett, 1992 Shareholder Letter

I received a lot of feedback, comments and a few questions after Connor Leonard’s guest post last week. Connor’s write-up was very well articulated, and deservedly received much praise. There were a few questions which we tried to address in comments and email responses, but one comment that came up a few times was: how do you calculate the return on reinvested capital?

I think a lot of people were looking for a specific formula that they could easily calculate. I think the concept that Connor laid out is what is most important. I think his examples did a nice job of demonstrating the power of the math behind the concept. His write-up also demonstrated why Buffett said those words in the 1992 shareholder letter that I quoted at the top of the post.

So the concept here is what needs to be seared in. In terms of calculating the returns on capital, each business is different and has unique capex requirements, cash flow generating ability, reinvestment opportunities, advertising costs, R&D requirements, etc… Different business models should be analyzed individually. But the main objective is this: identify a business that has ample opportunities to reinvest capital at a high rate of return going forward. This is the so-called compounding machine. It is a rare bird, but worth searching for.

I amalgamated a few of my responses to comments and emails into some thoughts using an example or two. These are just general ways to think about the concept that Connor laid out in the previous post.

Return on “Incremental” Invested Capital

It’s simple to calculate ROIC: some use earnings (or some measure of bottom line cash flow) divided by total debt and equity. Some, like Joel Greenblatt, want to know how much tangible capital a business uses, so they define ROIC as earnings (or sometimes pretax earnings before interest payments) divided by the working capital plus net fixed assets (which is basically the same as adding the debt and equity and subtracting out goodwill and intangible assets). Usually we’ll want to subtract excess cash from the capital calculation as well, as we want to know how much capital a business actually needs to finance its operations.

But however we precisely measure ROIC, it usually only tells us the rate of return the company is generating on capital that has already been invested (sometimes many years ago). Obviously, a company that produces high returns on capital is a good business, but what we want to know is how much money the company can generate going forward on future capital investments. The first step in determining this is to look at the rate of return the company has generated on incremental investments recently.

One very rough, back-of-the-envelope way to think about the return on incremental capital investments is to look at the amount of capital the business has added over a period of time, and compare that to the amount of the incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $111 billion debt and equity capital, or about a 13% return on capital. Not bad, but what do we really want to know if we were thinking about investing in Walmart?

Let’s imagine we were looking at Walmart as a possible investment 10 years ago. At that point in time, we would have wanted to make three general conclusions (leaving valuation aside for a moment):

  • How much cash Walmart would produce going forward?
  • How much of it would we see in the form of dividends or buybacks?
  • Of the portion we didn’t receive, what rate of return would the company get by keeping it and reinvesting it?

Our estimates to these questions would help us determine what Walmart’s future earning power would look like. So let’s look and see how Walmart did in the last 10 years.

In 2006, Walmart earned $11.2 billion on roughly $76 billion of capital, or around 15%.

In the subsequent 10 years, the company invested roughly $35 billion of additional debt and equity capital (Walmart’s total capital grew to $111 billion in 2016 from $76b in 2006).

Using that incremental $35 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return of about 10% on the capital that it has invested during that time.

Note: I’m simply defining total capital invested as the sum of the debt (including capitalized leases) and equity capital less the goodwill (so I’m estimating the tangible capital Walmart is operating with). I’ve previously referenced Joel Greenblatt’s book where he uses a different formula (working capital + net fixed assets), but this is just using a different route to arrive at the same basic figure for tangible capital.

There are numerous ways to calculate both the numerator and denominator in the ROIC calculation, but for now, stay out of the weeds and just focus on the concept: how much cash can be generated from a given amount of capital that is invested in the business? That’s really what any business owner would want to know before making any decision to spend money.

Reinvestment Rate

We can also look at the last 10 years and see that Walmart has reinvested roughly 23% of its earnings back in the business (the balance has been primarily used for buybacks and dividends). How do I arrive at this estimate? I simply used the amount of incremental capital that Walmart has invested over the past 10 years ($35 billion) and divide it by the total earnings that Walmart has generated during that period (about $148 billion of cumulative earnings).

An even quicker glance could simply be to look at the retained earnings on the balance sheet in 2016 ($90 billion) and compare it to the retained earnings Walmart had in 2006 ($49 billion), and arrive at a similar reinvestment rate: basically, Walmart is retaining roughly $0.25 of every $1 it earns and reinvesting it back into the business. The other $0.75 is being used for buybacks and dividends.

As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate (leaving aside capital allocation, which can increase or decrease value per share as well).

Intrinsic Value Compounding Rate = ROIC x Reinvestment Rate

There are other factors that can create higher earnings (pricing power is one big example), but this simple formula is helpful to keep in mind as a rough measure of a firm’s compounding ability.

So if Walmart can retain 25% of its capital and reinvest that capital at a 10% return, we’d expect the value of the company to grow at a rate of around 2.5% per year (10% x 25%). Stockholders will likely see higher per-share returns than that because of dividends and buybacks, but the total value of the enterprise will likely compound at roughly that rate. And over time, the change in value of the stock price tends to mirror the change in value of the enterprise plus any value added from capital allocation decisions.

Here is a table that summarizes the numbers I outlined above:

WMT ROIC

Not surprisingly, Walmart’s stock price is only about 45% higher (not including dividends) than it was 10 years ago. So unless you are banking on an increase in P/E ratios, you’re unlikely to achieve a great result buying a business that can only invest a quarter of its earnings at a 10% return.

Chipotle—A High Return on Capital Business

Let’s use the same principles to very briefly take a look at Chipotle, which is a business that has been able to reinvest its earnings at very high rates of returns over the past decade.

For Chipotle, we’ll look at the last 9 years of operating results starting at the end of 2006, which was the first year that Chipotle operated as a standalone company (McDonald’s spun it off in mid-2006).

Chipotle has great unit economics. In 2015, it cost $805,000 to build out the average restaurant which, when up and running, produces around $2.4 million in revenue and better than 25% restaurant-level margins. So an $800k initial investment produces around $600k of yearly cash flow. In other words, the average Chipotle restaurant has achieved an incredible 75% cash on cash return (this is restaurant-level ROI before corporate G&A expenses and taxes).

Over the past 9 years, Chipotle has grown from 581 restaurants to just over 2,000. They’ve invested a total of $1.25 billion to build out these restaurants which has increased its earnings by around $435 million. In other words, Chipotle saw around a 35% after-tax return on the capital it reinvested back into the business:

CMG ROIC

Chipotle was able to invest over half of its earnings at 35% returns, and using the formula described above to approximate intrinsic value growth, 57% reinvestment rate times 35% returns equals about a 20% increase in earning power.

The result is that the stock price has compounded at over 20% annually, very much in line with Chipotle’s intrinsic value.

Mature Businesses vs. Compounders as Investments

Of course, the hard part is finding these companies in advance. Also, we should remember that buying cheap and selling dear is a very good strategy, and there are plenty of opportunities in the market to do so with durable and established, but low-growth businesses. Peter Lynch called these companies stalwarts—they were big companies without a lot of growth potential, but occasionally you could buy them at a discount and sell them after a 30-50% rise (which largely comes from the valuation multiple increasing as opposed to the business value increasing).

That’s a good strategy, and there are probably more opportunities that Mr. Market offers in this particular category. But an investor should realize that these investments are not going to result in big compounding results. Lynch’s famous 10-baggers came from the rare companies that could retain their earnings and plow them back into the business at high rates of return for many years. The former is much more common and actionable, but it’s still worth hunting for stocks in the latter category in my opinion. You only need a few to make a career.

To Sum It Up

What you really want to know is this: At the end of the year, the company will have made a certain amount of money. Out of that pile of cash, you want to know:

  • How much can the company reinvest into the business?, and,
  • What the return will be on that investment?

If Walmart makes $16 billion, they might spend $4 billion on building out new stores. How much additional cash flow will come from that $4 billion investment?

Obviously, Walmart getting a 10% return on a quarter of its earnings is not nearly as attractive as Chipotle getting a 35% return on half of its earnings. The latter is going to create much more value than the former.

This is a really rough measure of how to think about return on capital, but it’s generally how I think about it.

Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed. There are also “investments” that don’t always get categorized as capital investments but run through the income statement—things like advertising expenses or research and development (R&D) costs. To be accurate, you’d want to know what portion of advertising is needed to maintain current earning power (akin to “maintenance capex”). The portion above that number would be similar to “growth capex”, which could be included when thinking about return on capital. R&D could be thought of the same way.

But hopefully this is a helpful example from a very general point of view on how to think about the concept. As a business owner, you want to know where you can reinvest your company’s excess cash flow and what rate of return you can get from those investments. The answers to those two main categories will in part determine how fast your business grows its earning power and increases its value.


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’ve talked a lot about the importance of the concept of return on invested capital (ROIC), and how it is a key driver of value in a business. Feel free to go back and read some of those posts here. In this particular post, the discussion is continued. This post is something new for BHI: it’s a guest post written by my good friend Connor Leonard (see his brief bio at the end of the post).

Connor and I live in the same area (Raleigh, North Carolina), and we get together on a regular basis to discuss businesses we follow as well as investment strategy. He and I think very similarly when it comes to investing in high quality businesses that can create significant value over the long-run. Connor is a smart investor, and I appreciate his willingness to be a sounding board for me at times.

This post contains his own thoughts (unedited by me) regarding the importance of a company being able to retain and reinvest its cash flow at high rates of return. I think he articulates the concept very well.

Here is Connor’s post:

The Reinvestment Moat

Outstanding companies are often described as having a “moat”, a term popularized by Warren Buffett where a durable competitive advantage enables a business to earn high returns on capital for many years[1]. These businesses are rare and form a small group, however I bifurcate the group further into what I classify as “Legacy Moats” and “Reinvestment Moats”. I find that most businesses with a durable competitive advantage belong in the Legacy Moat bucket, meaning the companies earn strong returns on capital but do not have compelling opportunities to deploy incremental capital at similar rates.

There is an even more elite category of quality businesses that I classify as having a Reinvestment Moat. These businesses have all of the advantages of a Legacy Moat, but also have opportunities to deploy incremental capital at high rates. Businesses with long runways of high-return investment opportunities can compound capital for long stretches, and a portfolio of these exceptional businesses is likely to produce years of strong returns. It will take some work and a lot of discipline to filter down to the true compounding machines, however I will outline what factors to look for and how many of the “bargains” hide in plain sight.

The “Legacy Moat”:

Businesses with a Legacy Moat possess a solid competitive position that results in healthy profits and strong returns on invested capital. In exceptional cases, a company with a Legacy Moat employs no tangible capital and can modestly grow without requiring additional capital. However because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners.

Think of a self-storage facility in a rural town with a high occupancy rate and little competition. This location may be generating $200,000 of annual free cash flow, a solid yield on the $1,000,000 of capital used to build the facility. As long as they run a tight operation, and a competing storage facility doesn’t open across the street, the owner can be reasonably assured that the earnings power will persist or modestly grow over time.

But what does the owner do with the $200,000 that the operation generates each year? The town can’t really support another location, and nearby towns are already serving the storage demand adequately. So maybe the owner invests it in another private business, or puts it towards savings, or maybe buys a lake house. But wherever that capital goes, it likely won’t be at the same 20% return earned on the initial facility.

This same dilemma applies to many larger businesses such as Hershey’s, Coca-Cola, McDonald’s or Proctor & Gamble. These four companies on average distributed 82.4% of their 2015 net income out to shareholders as dividends. For these companies that decision makes sense, they do not have enough attractive reinvestment opportunities to justify retaining the capital.

Even though these Legacy Moat businesses demonstrate high returns on invested capital (ROIC), if you purchase their stock today and own it for ten years it is unlikely you as an investor will achieve exceptional returns. This is because their high ROIC reflects returns on prior invested capital rather than incremental invested capital. In other words, a 20% reported ROIC today is not worth as much to an investor if there are no more 20% ROIC opportunities available to direct the profits.

Equity ownership in these businesses ends up resembling a high-yield bond with a coupon that should increase over time. There is absolutely nothing wrong with this, businesses like Proctor & Gamble and Hershey’s provide a steady yield and are excellent at preserving capital but not necessarily for creating wealth. If you are looking to compound your capital at unusually high rates, the focus needs to shift to identifying businesses that also possess a “Reinvestment Moat”.

The “Reinvestment Moat”:

There is a second group of companies that have all the benefits of a Legacy Moat, but also have opportunities to deploy incremental capital at high rates because they have a Reinvestment Moat. These companies have their current profits protected by a Legacy Moat, so the core earnings power should be maintained. But instead of shipping the earnings back to the owner at the end of each year, the vast majority of the capital will be retained and deployed into opportunities that stand a high likelihood of producing high returns.

Think of Wal-Mart in 1972. There were 51 locations open at the time and the overall business generated a 52% pre-tax return on net tangible assets. Clearly their early stores were working, they dominated small towns with a differentiated format and a fanatical devotion to low prices. Within the 51 towns, I would bet that each store had a moat and Sam Walton could be reasonably assured the earnings power would hold steady or grow over time. Mr. Walton also had a pretty simple job when it came to deploying the cash those stores generated each year. The clear path was to reinvest the earnings right back into opening more Wal-Marts for as long as possible. Today there are over 11,000 Wal-Mart locations throughout the world and both sales and net income are up over 5,000x from 1972 levels.

How To Identify a Reinvestment Moat:

When searching for a Reinvestment Moat, I’m essentially looking for a business that defies capitalism. Isolated profits in a small market is one thing, but continuing to achieve high returns on incremental dollars for years should in theory not be attainable. As a business gets bigger, and the profits become more meaningful, it will attract more and more competition and returns should eventually compress. Instead I’m looking for a business that actually becomes stronger as it gets bigger. In my opinion there are two models that lend itself to this kind of positive reinforcement cycle over time: companies with low cost production or scale advantages and companies with a two-sided network effect.

Low Cost / Scale:

Going back to the early Wal-Mart example, the stores were so big compared to traditional five and dimes that Mr. Walton could sell each item at a lower margin than competitors and still operate profitably due to the large volume of shoppers. The more people that shopped at a given Wal-Mart, or the more Wal-Marts that were built, only furthered this cost advantage and widened the moat. The lower prices enticed more shoppers, and the cycle continues to reinforce itself. So by the time there were 1,000 Wal-Marts in existence, the moat was significantly wider than when there were 51. Other businesses such as Costco, GEICO, and Amazon have followed a similar playbook, creating a “flywheel” that accelerates as the business grows[2].

Example: Sketch of the Amazon Flywheel

Connor-Amazon Flywheel

Two-Sided Network:

Creating a two-sided network such as an auction or marketplace business requires both buyers and sellers, and each group is only going to show up if they believe the other side will also be present. Once the network is established however, it actually becomes stronger as more participants from either side engage. This is because the network is stronger for the “n + 1,000th” participant compared to the “n” participant directly as a function of adding 1,000 participants to the market[3].  Another way of describing this: as more buyers show up it will attract more sellers, and that in turn will attract more buyers. Once this positive cycle is in place, it becomes nearly impossible to convince either buyer or seller to leave and join a new platform. Businesses such as Copart, eBay, and Airbnb have built up strong two-sided networks over time.

Andreesen Horowitz’s example of Airbnb’s two-sided network:
Connor-Horowitz

Judging the “Runway” to Reinvest:

Many investors focus purely on growth rates, driving up the valuation of a company growing at high rates even if the growth does not carry positive economics. The key to Reinvestment Moats is not the specific growth rate forecasted for next year, but instead having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time. Instead of focusing on next quarter or next year, the key is to step back and envision if this company can be 5x or 10x today’s size in a decade or two? My guess is for 99% of businesses you will find that it is almost impossible to have that kind of conviction. That’s fine, be patient and focus your energy on identifying the 1%.

Admittedly this is the most difficult step of the process, with many variables and uncertainties. Each situation will be different, but below are items I look for as positive indicators of a long runway and also red flags that the runway is concluding:

Positive Indicators:

If a two-sided network is consistently increasing key metrics like users or gross transactions but is still a small percentage of the overall market:

  • Focus on companies with a high “flow through” margin on an incremental user or transaction, which will help the company expand margins as the network grows.

If a company has a structural advantage that leads to a lower cost model than competitors:

  • This could be a differentiated business model such as selling direct rather than through agents. Or it could be an advantage developed over time such as technology that results in greater automation. The structural advantage has to be difficult for larger incumbents to duplicate.

If a multi-unit retailer currently has less than 100 locations but foresees an end market of over 1,000:

  • Focus on companies with a consistent, profitable, and replicable model. The company should primarily be “stamping out” the same prototype over and over while producing consistent unit economics.

Red Flags:

If a company that claims to have a long runway begins shifting into new or different markets:

  • If the future is so bright, then why deviate from the plan? The management may already know the runway is limited and is making a pivot.

If management’s definition of the total addressable market (TAM) is suspect:

  • Some management teams like to throw out a massive TAM number in a slide deck for investors to focus on. Check the underlying source of that number, if their definition is overly broad they may be trying to mislead investors.

If the recent vintages of growth investments are producing lower returns:

  • If the most recent stores opened are producing lower sales and margins, but cost just as much, the runway is showing some cracks. Many multi-unit businesses begin to show lower unit returns once outside of core markets.

Why Value Investors Often “Miss” the Reinvestment Moats:

I believe identifying these businesses with Reinvestment Moats is possible with some work, but many value investors struggle with identifying a “reasonable” price. My theory is that these Reinvestment Moats tend to “hide in plain sight” because most investors underappreciate the impact of compounding.

When assessing a quality business, value investors will often point to a P/E ratio over 20x or the EV/EBITDA multiple of 10x+ to show that Ben Graham would surely shake his head in disgust over such a purchase[4]. However let’s consider two investments and determine which will yield better results over a ten year horizon. The first business, Reinvestment Corp., has the ability to deploy all retained earnings at a high rate because of the strong Reinvestment Moat it possesses. Of course investors acknowledge this likelihood, meaning the entry price is fairly high at 20x earnings, leading most bargain hunters to pass. On the other hand, Undervalued Corp. has all of Graham and Doddsville in a buzz because it’s a steady business with a nice dividend selling for a bargain of only 10x earnings! Assume that over time both companies will be valued in-line with the market at 15x:

Connor-Reinvestment vs Legacy 1
*Assumes all earnings not reinvested are distributed as dividends                                                                                            
**Pre-tax IRR, factoring in tax rates will only further the advantage of Reinvestment Corp.               

This example illustrates a concept Charlie Munger outlined in “The Art of Stockpicking”:

“If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

To create an even more extreme example, if you find a business that you believe is capable of earning strong returns over a decade, look at how much you can “overpay” and still earn a return equal to a typical business:

Connor-Reinvestment vs Legacy 2
*Assumes all earnings not reinvested are distributed as dividends       
                                                                                     **Pre-tax IRR           

Time is certainly the friend of a great business. But does this mean that only businesses with a Reinvestment Moat should be considered for a long-term investment?

Earning High Returns Investing in Legacy Moats:

A solid Legacy Moat paired with the right management team and strategy can be a wealth creator for shareholders over many years. In order to accomplish this, the playbook has to change into one more focused on capital allocation, specifically a systematic focus on acquisitions and managing the capital structure. In a sense the management team’s capital allocation prowess must become the Reinvestment Moat.

While the research on the negative consequences of M&A for corporations is extensive, I think there are a select group of management teams that can actually reinvest the company’s capital better than individual shareholders could do on their own. They tend to operate solely within their circle of competence, which is typically the sector where the underlying business resides. With deep industry knowledge, access to deal flow, and the ability to achieve operational synergies, these companies can operate like a private equity fund with permanent capital (and without the fee structure). Notable examples include TransDigm Group, Danaher Corporation, and Constellation Software.

Typically the management team consists of at least one “Operator” and a sole “Allocator”. The Operator is tightly managing the existing businesses to maintain their competitive positions. The Allocator functions more as an investor than a CEO, seeking out opportunities to deploy capital at high rates while also optimizing the capital structure. For the Allocator the capital structure is another means of creating shareholder value, and it is common to see special dividends, strategic use of leverage, and lumpy share buybacks that only occur when the stock is undervalued. William Thorndike’s book “The Outsiders” does a fantastic job of detailing these unique management teams with a talent for capital allocation.

I’ve found that the best way to find these companies is by reading annual shareholder letters and picking up on certain qualitative patterns.  First, a thoughtful and informative annual letter is key because it shows the managers view the shareholders more as business partners and co-owners rather than a pesky group they have to deal with each quarter. While I prefer to do further research, typically the letter is so insightful to a potential owner that they could make an informed investment decision simply by reading it each year. The letters typically contain terms like “intrinsic value”, “return on capital employed”, and “free cash flow per share” rather than simply discussing sales growth. These businesses tend to view frugality as a source of pride, with the home office setting the tone that each dollar is valuable because it ultimately belongs to the shareholder. If you happen to come across one of these companies, and you think the management team has a number of years remaining with plenty of attractive M&A targets, my advice is to buy the shares and let them take care of the compounding for you.

Summary:

Most of the companies that are identified as having a “moat” tend to be Legacy Moats that produce consistent, protected earnings and strong returns on prior invested capital. These are perfectly good businesses and can produce nice returns for investors in a comfortable fashion.

However if you aiming to compound capital at high rates, I believe you should spend time focusing on businesses possessing a Reinvestment Moat with a very long runway. These businesses exhibit strong economics today, but more importantly possess a long runway of opportunities to deploy capital at high incremental rates. If these are hard to come by, the next best alternative is a business with the combination of a Legacy Moat and an exceptionally strong capital allocator. It will take some work and a lot of discipline to filter down to the true compounding machines, however a portfolio of these exceptional businesses acquired sensibly is likely to produce years of strong returns.

[1] If you are new to the concept of “moats”, this video of Buffett speaking to MBA students at the University of Florida does as far better job of describing the concept than I can: https://youtu.be/r7m7ifUz7r0?t=108  

[2] The concept of a flywheel is popularized by Jim Collins, you can read more about it here: http://www.inc.com/jeff-haden/the-best-from-the-brightest-jim-collins-flywheel.html

[3] This description of the strength of a network business is taken from venture capitalist Bill Gurley

[4] According to the postscript to the revised edition of the Intelligent Investor, Ben Graham made more money off his stake in GEICO (a true Reinvestment Moat with lost-cost advantages) than he did from every other investment in his partnership over twenty years combined. At the time of the GEICO purchase, Graham allocated about 25% of the partnership’s funds towards the investment.

John’s Comment: Thanks again to Connor for putting this guest post together. I think it is a good extension of some of the investment concepts we’ve talked about here before. For related posts on this topic, please review the ROIC label as well as a recent post I did summarizing the talk that Connor referenced where Buffett does a particularly great job summarizing some of his investment tenets, including the concepts discussed in this post.


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.


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 established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

John can be reached at john@sabercapitalmgt.com

I read an article last week by Scott Fearon, who wrote the excellent book Dead Companies Walking (a good book about shorting stocks, which can benefit investors even if they don’t short stocks). The article basically posed a hypothetical question on whether Apple was a better investment than Exxon Mobil. Fearon goes on to explain why he thinks XOM is a better bet than AAPL over the long-term.

His points:

  • Apple is a consumer products company with the majority of revenues coming from one product class—the iPhone
  • Consumer products can be very difficult to predict and can go in and out of demand very quickly
  • Exxon is a more predictable company that sells products that are essential to the world’s economy
  • He implies that Exxon has a stronger balance sheet than Apple

While I often agree with many of Scott’s opinions in his posts, I’ll make just a few counterarguments to his opinion that Exxon is a better business than Apple. This isn’t a write-up on why I like Apple, or why I don’t like Exxon (I actually don’t have much of an opinion of Exxon either way). These are just a few comments on the two. At some point, I’ll discuss more details on why I do actually like Apple as a business.

Exxon Sells a Commodity Product

Scott mentions that he was concerned that once the iPhone sales started falling that the stock would fall with it. That has in fact happened just as Scott predicted. Apple’s revenue fell 13% and profit fell 22% in the recent quarter. That said, Exxon’s revenue fell 28% and its profit fell 63% due to the brutal conditions in the energy industry. 

The problem I see with Exxon is that while it is the largest integrated (diversified) oil company, it still sells a commodity product. The problem inherent to a business that sells a commodity product is that they have no control over the price of the main product they sell. Not only does a commodity producer have no control over the price of their product, but they have no idea what the spot price of that product will be in any given year. It could be 100% higher one year, and 60% lower the next year. It’s generally a difficult business when you have no control over the price of the product that you sell, especially when a good amount of your input costs are fixed (i.e. if oil goes from 100 to 40, there are certain operating expenses that don’t drop with it—some costs do fall, but not necessarily by 60%).

A lot of people are worried about Apple’s ASP (average selling price) falling as they face competitive pressures as well as a possible shift toward smaller phones. But the “ASP” of one of Exxon’s main products (a barrel of oil) has dropped from around 110 to 45 in the past 18 months. Exxon is certainly strong enough to survive this, but that’s a difficult business to be in.

Exxon is More Predictable

I do agree that it is easier to look out 10 or 20 years and visualize what Exxon will be doing. They’ll still be drilling and pulling oil out of the ground 10 or 20 years from now (yes, the developed world will still be using fossil fuels as a primary energy source a decade or two from now). But just understanding what a business will likely be doing 10 years from now doesn’t necessarily make it a great investment. The company might struggle to create incremental value for shareholders during that time.

Take US Steel for example. It’s quite predictable that US Steel will still be producing steel 10 years from now, but that doesn’t mean that the stock will end up being a great buy and hold investment. In fact, it doesn’t even necessarily guarantee that the equity will survive—but US Steel will still be making steel in a decade or two. But 25 years ago, X traded around 26 and today it trades around 16.

As Charlie Munger warned in his discussion on cattle at the Berkshire AGM, it’s probably best to avoid commodity businesses that don’t produce decent returns on capital.

US Steel

Just because you can visualize what a company will be doing in a decade doesn’t mean that the intrinsic value of the business will grow or that the equity is a good investment.

To be clear, Exxon Mobil is a much better business than US Steel. I’m not suggesting the two are similar (except that they are both commodity producers). My point is simply that predictability doesn’t necessarily lead to value creation. As Buffett rightly points out, being able to understand what a business will look like in 10 years is an important prerequisite for an investment, but being able to see what products and services a business will sell in 10 years doesn’t necessarily mean that there is a high level of predictability around the company’s earning power.

Apple’s Balance Sheet

Apple has a cash hoard of roughly $233 billion, and after subtracting all debt, Apple has a net cash position of $161 billion, or roughly $29 per share. Scott mentioned that Apple will need to use much of this to invest in research and development projects in order to continue producing innovative products.

Let’s take a look at Apple’s R&D spending the last five years:

  • 2011: $2.4 billion spent on R&D
  • 2012: $3.5 billion
  • 2013: $4.5 billion
  • 2014: $6.0 billion
  • 2015: $8.1 billion

To put these numbers in perspective, the R&D spending ranges between roughly 2.0% and 3.5% of Apple’s revenue. In the past 5 years, Apple has produced a combined $283.1 billion in operating cash flow (and this is after deducting the R&D expenses which run through the income statement). Apple’s total capital expenditures over that five year period were $47.3 billion—much of which would be categorized as “growth capex”. So even after deducting all capex, Apple has produced a combined $235.8 billion in cumulative free cash flow (FCF) over the past 5 years, or an average of roughly $47 billion FCF per year.

It’s hard to suggest—even assuming worse than expected sales declines—that Apple’s business model is going to require it to wind up using most of the cash hoard to finance capital investments and research projects when the operating business produces FCF that is 6 times larger than the R&D budget.

In other words, Apple could double or triple its R&D spending and still–even with worse than expected sales declines–add significant amounts of cash to its balance sheet.

Another way to look at the size of the cash is this: if Apple could somehow take its cash hoard and find a place to get 3% after-tax returns, it would produce $8 billion of interest from its cash, enough to finance the entire R&D budget from 2015 without even tapping principal. This doesn’t include the $40 billion or so of FCF that Apple will have this year to either pay out as dividends, buyback stock, or add to its growing pile of cash. I’m not suggesting Apple will or should invest in low-earning income securities, but this should help illustrate how much earning potential Apple has from its balance sheet to finance its spending.

Exxon’s Balance Sheet

On the other hand, let’s briefly glance at Exxon’s balance sheet. There is $4.8 billion of cash and roughly $43 billion of debt. Exxon has also produced a huge amount of cash flow over the past 5 years, and has historically produced a sizable amount of free cash flow as well. Over the past 5 years, the company has averaged $14.7 billion annually in FCF.

The problem is that over the past 5 years, Exxon has spent an average of $15.2 billion per year on stock buybacks and an additional $11.0 billion per year on dividends. So a business with around $15 billion of free cash flow is not producing enough cash to finance its $26 billion of average capital returns (buybacks and dividends). Obviously, buybacks can easily be cut as earnings decline, but in recent quarters, the free cash flow (the amount of money the business generates to pay for things like buybacks and dividends) is not enough to even support the dividend. This is largely the reason Exxon’s debt has gone from $15 billion to $42 billion over the past 5 years. In 2015, Exxon’s free cash flow was just $3.9 billion, which was significantly less than the $12.3 billion that Exxon spent just on the dividend.

Buybacks have dropped from $22 billion at the peak to just $4 billion last year, but if conditions in the energy industry continue, Exxon could be forced to either continuing taking on large amounts of incremental debt each year to finance the dividend, or cut the dividend down to a level that can be financed out of the company’s free cash flow.

I am not making a prediction or casting judgment on the future of Exxon’s business (or its dividend), but I certainly view it in a much more precarious situation than Apple (which will most likely do somewhere between $40 billion and $50 billion of free cash flow this year—plenty to pay for its $13 billion dividend payment and still have much left over to buy back shares or add to its massive cash position).

To Sum It Up

The two businesses are like comparing apples (no pun intended) and oranges, but the articles Scott wrote got me thinking about the two last week. 

I recommend his book, which is a good read regardless of whether you short stocks or not. Thinking like a short seller is a very important skill to develop for any investor, as it helps you poke holes in your own potential investment ideas with a more discerning eye.

As far as this comparison between Exxon and Apple, it is more of just a random thought experiment without much relevance (since the two are unrelated businesses). But still it was interesting to consider the respective futures of the two since they are two of the largest companies in the market. In the near future, I’ll probably put up a post on why I like Apple as a business and an investment, which might be contrarian in the value community given the current view that the company is just another consumer electronics business. I currently 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.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

I spent some time traveling in the car last week. Whenever I am driving by myself, I always listen to something—usually related to business or investing. I keep a long list of videos of interviews or talks that I can pick from whenever I am in the car. On this particular short trip, I had got through two different videos. I listened to this talk from 2012 where Jeff Bezos talks about Amazon Web Services—the cloud computing services business that Amazon has built into a juggernaut. It’s a pretty good talk that outlines much of how Bezos thinks about not just AWS, but his retail business in general.

The second video was a talk that Buffett gave to a group of students at the University of Florida back in 1998. I’ve listened to this video numerous times over the years, but it is one that I have on my favorites list and is worth listening to every year or two.

After Omaha last week, I heard someone say that Buffett and Munger “never say anything new”. This comment was probably out of frustration that Buffett and Munger didn’t unveil some secret formula for success in investing.

The fact that these guys have been so successful by sticking to the same gameplan—in terms of general investment principles—should actually be a lesson in itself. Never wavering on their basic philosophy has brought them a long way. Tactics have changed over time as they’ve grown, but the concepts they implemented very early on have remained the same.

The University of Florida talk from 1998 is one of the best when it comes to articulating very clearly these investment principles that have served Buffett and Munger so well for so long. There is nothing “new”, but sometimes just going back to the basics is beneficial.

Here are some highlights from the talk (along with the time in the video of the comments):

On the Economics of Good Businesses (11 minute mark)

In response to a question about Japan, Buffett mentions how most Japanese businesses produce low returns on equity, and how time works against you when you own low return businesses:

“Japanese companies earn very low returns on equity. They have a bunch of businesses that earn 4%, 5%, or 6% returns on equity. It’s very hard to earn a lot as an investor when the business you’re in doesn’t earn very much money.”

Buffett goes on to explain that some people can invest profitably in such businesses, and he talks about how he used this method in the early years. He also references Walter Schloss, who made a career out of owning such businesses. Schloss would buy low earning (or sometimes money-losing) businesses that were trading below the value of the net tangible assets the company owned. It’s an approach that can work well, but I’ve found that it’s an uncomfortable way to invest—it often means owning bad businesses, and I prefer avoiding bad businesses. I’ve found that when I’ve owned bad businesses because I was attracted to the valuation, I become much more influenced and concerned with the behavior of the stock price, or even the general economy. Many bad businesses trade cheaply, but won’t survive the next recession. Glenn Greenberg once said that he wanted his portfolio filled with stocks that he would feel comfortable owning if a 1987-style stock market crash occurred (when the market plummeted over 20% in one day). I won’t comment on his largest current position or any other stocks in his portfolio, but I do think there is a lot of merit in that concept. If you own good businesses with strong earning power, you’re less concerned (or hopefully not concerned at all) about the stock market or the near term prospects for the economy.

The other problem with a Schloss-type approach is it requires a plethora of ideas that have to be continually replaced. Because the businesses are of low quality in some cases, you need plenty of diversification. Also, since you have to sell these stocks as soon as the price gets a modest bump, you need to be constantly looking for the next idea.

I think Schloss’ asset-based approach worked well in part because the US economy was much more manufacturing-oriented in the 1950’s, 60’s and 70’s. Manufacturing was responsible for just 12% of US GDP in 2015, down from 24% in 1970. Service producing businesses have taken share from goods producing businesses, and now make up a much greater piece of the overall economic pie, and these service businesses tend to operate with much lower amounts of tangible capital. Trying to find service businesses trading below book value is a mostly irrelevant and futile exercise—the ones that do tend to be going out of business, and rarely do these make attractive investments.

But the concept of buying cheap “cigar butt” stocks vs buying good businesses is a debate that still goes on, and both approaches can work, but the tactics involved are very different.

As I’ve talked about before, I think Buffett grasped the power of owning good businesses at a much earlier age than many people realize.

Buffett caps off this question by saying:

“If you’re in a lousy business for a long time, you’re going to get a lousy result even if you buy it cheap.”

Long-Term Capital Management (13 minute mark)

Buffett talks about the background of LTCM, which is a fascinating story in general. One of my favorite books on the topic is When Genius Failed by Roger Lowenstein. This book is a must read for all investors in my opinion.

He uses the story as a teaching moment, and discusses the dangers in leverage, overconfidence, and numerous other biases/mistakes that were made by incredibly smart people.

The takeaway here is that formulas and mathematics only take you so far. You need to apply logic and reason to risk management, not just computer-driven models:

“Those guys would tell me back when I was at Solomon that a six-sigma event wouldn’t touch us. But they were wrong. History does not tell you the probabilities of future financial things happening.”  

How do you decide how much to pay for a business? (32 minute mark)

This is an interesting question because Buffett—despite producing incredible returns in his partnership and the early Berkshire years—says he was never trying to go for home-run type returns. He was more focused on finding the sure bets—investments where he was fairly certain to make money without taking much risk:

“I don’t want to buy into any business that I’m not terribly sure of. So if I’m terribly sure of it, it probably isn’t going to offer incredible returns. Why should something that is essentially a cinch to do well offer you 40% a year or something like that? So we don’t have huge returns in mind. But we do have in mind never losing anything.”

He uses Sees Candy as a case study for how he thinks about what to pay for a business. They bought Sees in 1972 for $25 million. It was selling 16 million pounds of candy at $1.95 per pound, and making $4 million pretax. He said that he and Munger basically had to decide if there was some untapped pricing power. If they could sell candy at $2.25 a pound, then $0.30 per pound on 16 million pounds was another $4.8 million of pretax profit on the same volume, which would have doubled the then-current earning power of the business. Even raising prices by a nickel per pound would have produced a 20% gain in pretax earnings.

What I find interesting is that the purchase price itself was quite cheap—just 6 times pretax earnings, the equivalent of an after-tax P/E of about 10. But Buffett never even mentions the valuation in answering the question—almost as if it was an afterthought. Notice how this was very similar even in his early two writeups of GEICO and Western Insurance–much more focused on the business, with barely a mention of valuation.

With Sees, he talked about the pricing power, references the return on capital (in this case Sees basically needed no capital), and talked about the attractiveness of the product. In the end, the decision to buy the business was made not based on whether the “multiple” was cheap enough, but because he and Munger decided the product had plenty of untapped pricing power—in other words, the product itself was very undervalued from the customer’s point of view. They surmised they could raise prices and still maintain or grow volumes.

Buffett and Munger were correct in their view that the product was undervalued, and through pricing power and unit growth, Sees has produced over $1.9 billion in pretax profits to Berkshire from an incremental investment of just $40 million and a purchase price of $25 million.

Sees is an extreme example to be sure, but one that exemplifies why it’s more important to be right on the business than right on the exact price to pay.

Qualitative vs. Quantitative (39 minute mark)

“The best buys have been when the numbers almost tell you not to.”

On Thinking Long-Term (45 minute mark)

“Coke went public in 1919. Stock sold for $40 per share. One year later it’s selling for $19—down 50% in one year. Now you might think that’s some kind of disaster, and you might think that sugar prices increased or the bottlers were rebellious… you could always find a few reasons why that wasn’t the ideal moment to buy it. Years later you would have seen the great depression, World War II, sugar rationing, thermonuclear weapons… there is always a reason. But in the end, if you would have bought one share for $40 and reinvested dividends, it would be worth about $5 million now.”

Coke is obviously another rare example of a business that has survived and prospered for many decades, but Buffett’s main point is the thing to focus on:

“If you’re right about the business, you’ll make a lot of money.”

Focusing on the “what” is more important than focusing on the “when”.

On Mistakes (49 minute mark)

Berkshire Hathaway itself is a mistake he often talks about (when it was a cigar-butt business that consumed a lot of cash and never really made any money).

He also brings up an interesting point: buying attractive securities of a business that he didn’t really like. He mentions two examples: buying preferred stock in both Solomon and US Air. In both situations, Buffett ended up okay, but he came very close to losing a significant amount of his principal in both of these investments. He sums up the lesson:

“We bought an attractive security in a business I wouldn’t have bought the equity in. You could say that’s one form of mistake—buying something when you like the terms but you don’t like the business that well.”

I think this could be extended to buying stocks when you like the terms (i.e. the valuation) but not necessarily the business.

Macro (54 minute mark)

“I don’t think about the macro stuff. What you really want to do in investments is figure out what’s important and knowable.”

He says macroeconomics (interest rates, economic trends, etc…) are important, but unpredictable.

He mentions what a mistake it would have been to not buy Sees Candy for $25 million (a business that was producing $60 million pretax in 1998 at the time of this lecture) because of some fear of interest rates or the near term economy (the US did in fact enter a significant recession and bear market in 1973-1974).

General Portfolio Management (60 minute mark)

“We never buy a stock with a price target in mind. We never buy something at 30 and say ‘if it goes to 40 we’ll sell it.’… That’s just not the right way to look at a business.”

Buffett obviously does buy and sell stocks—and did much more of that in his early years—but the concept is to focus on stocks not as trading vehicles with price targets, but as businesses that produce cash flow for owners. Mr. Market will always be there offering prices that can be taken advantage of, but the mindset should be firmly focused on the fundamentals of the business and its future earning power, not on where the stock will go or when it will get there.

Diversification (66 minute mark)

Buffett says that for most individuals, owning an index fund is the appropriate investment for stocks. But for those who desire to treat investing as a business and have an ability to analyze companies, diversification is a mistake:

“If you really know businesses, you probably shouldn’t own more than 6 of them. If you can identify six wonderful businesses, that is all the diversification you need and you’re going to make a lot of money, and I will guarantee you that going into a seventh one rather than putting more money in your first one is a terrible mistake.”

This is interesting because Berkshire obviously owns more than 6 businesses, but it’s probably more useful to look back at how Buffett ran money when he had small sums. His personal account was very concentrated (he did 50% returns by owning just a few stocks at a time in the 1950’s), and his partnership—according to the details laid out in Snowball—often had 3 or 4 stocks representing over half the portfolio—sometimes his best idea represented 25-40% of capital.

To Sum It Up

There are other valuable passages that I didn’t highlight, but the entire video is worth spending 90 minutes to watch. There is nothing new in it, just as the shareholder meeting this past weekend had nothing “new”, but sometimes it’s worth listening to the best investor in the world articulate his own philosophy in his own words—even if that philosophy is already seared into your mind.