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1987 Berkshire Letter and Buffett’s Thoughts on High ROE

I am in the midst of writing a few posts on the importance of Return on Invested Capital (ROIC). I wrote two posts last week discussing Greenblatt’s formula and some thoughts on the topic (Here and Here). I’ll have one or two more posts next week discussing a few brief examples of compounders (companies that exhibit unusually high returns on capital over extended periods of time, allowing them to grow–or “compound”–shareholder value over long periods of time).

There always seems to be a strong divide between “value and growth“, deep value (aka cigar butts) and quality value, etc… I too have mentioned these differences numerous times. And it’s true that many investors can do well simply buying great businesses at fair prices and holding them for long periods of time, while other investors prefer to slowly and steadily buy cheap stocks of average quality and sell them as they appreciate to fair value, repeating the process over time as they cycle through endless new opportunities.

The styles are different, but not as different as most people describe them to be. The tactics used are different, but the objective is exactly the same: trying to buy something for less than what its really worth. Both strategies rely on Graham’s famous “margin of safety” concept, which is probably the most important concept in the investing discipline.

Both Quality and Valuation Impact Margin of Safety

The margin of safety can be derived from the gap between price and value, and it can also be derived from the quality of the business. The latter point is really part of the former… For example, a business that can steadily grow intrinsic value at a rate of say 12% annually is worth much more than a business that is growing its value at say 4% annually–all other things being equal. And since the higher quality compounder is worth more than the lower quality business, the quality compounder offers a larger margin of safety.

Of course, in the real world, it’s not that easy. The lower quality business might offer an extremely attractive discount between current price and value, which is significant enough to make the investment opportunity preferable to the compounder. This is often the case in real life–compounders are rarely are offered cheaply.

But too often, value investors get enticed by cheap metrics and seemingly large discounts between price and value in businesses with shrinking intrinsic value. The problem in these types of cigar butts is that the margin of safety (gap between purchase price and value) is largest the day of the investment. Every day thereafter the business value slowly erodes further, making the investment a race against time.

Now, not all cheap stocks have eroding intrinsic value. On the contrary, many high quality, or average quality businesses are occasionally offered quite cheap. But in my opinion, it’s always much more reassuring to be invested in businesses that have intrinsic values that are growing over time, as it allows for larger margins of error in the event that you’re wrong, and better returns in the event that you’re right. A couple days ago I read a quote somewhere that I believe Allan Mecham said that I’ll paraphrase: If investors focused on reducing unforced errors as opposed to hitting the next home run, their returns would improve dramatically.

So it’s like the amateur tennis champion that wins because they had the fewest mistakes, not necessarily the most forehand winners.

Reducing Unforced Errors and Buffett’s 1987 Roster

One way to reduce unforced errors in investing is to carefully choose the businesses that you decide to own. The gap between price and value will ultimately determine your returns, but picking the right business is one important step in reducing errors.

One way to reduce errors is to focus on studying high quality businesses with high returns on capital. In the last post, I mentioned an article that Buffett referenced in the 1987 Berkshire shareholder letter. In this letter, Buffett mentions that Berkshire’s seven largest non-financial subsidiary companies made $180 million of operating earnings and $100 million after tax earnings. But, he says “by itself, this figure says nothing about economic performance. To evaluate that, we must know how much total capital – debt and equity – was needed to produce these earnings.

So Buffett was interested in return on invested capital. However, he goes on to state that these seven business units used virtually no debt, incurring just $2 million of total combined interest charges in 1987, so virtually all capital employed to produce those earnings was equity capital. And these 7 businesses had a combined equity of only $175 million.

So Berkshire had seven businesses that combined to produce the following numbers:

  • $178 million pretax earnings
  • $100 million after tax earnings
  • $175 equity capital
  • 57% ROE
  • 102% Pretax ROE

So Buffett’s top 7 non-financial businesses produced fabulously high returns on equity with very little use of debt. In short, they were outstanding businesses. Buffett proudly goes on to say that “You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.” Of course, investor returns depend on price paid in relation to value received, and we are only discussing the value received part of the equation here.

Buffett then voices his opinion on the importance of predictability and stability in business models:

Buffett Shareholder Letter 1987 Clip

He then references an interesting study by Fortune that backs up his empirical observation. In this study, Fortune looked at 1000 of the largest stocks in the US. Here are some interesting facts:

  • Only 6 of the 1000 companies averaged over 30% ROE over the previous decade (1977-1986)
  • Only 25 of the 1000 companies averaged over 20% ROE and had no single year lower than 15% ROE
  • These 25 “business superstars were also stock market superstars” as 24 out of 25 outperformed the S&P 500 during the 1977-1986 period.

The last statistic is remarkable. Even in the really high performing value baskets such as low P/B or low P/E groups, you’ll typically see a ratio of around one-half to two-thirds of the stocks that outperform the market. Sometimes you’ll even have a majority of underperformers that are paid for by a few large winners in these basket situations. But in this case, even with a small sample space, it’s pretty telling that 96% of the group outperformed over a period of meaningful length (10 years).

Of course, this begs a question along the following lines: “Great, by looking in the rear view mirror, it’s easy to determine great businesses… how do we know what the next 10 years will look like?”.

Buffett again provides some ideas:

Buffett Shareholder Letter 1987 Clip 2

The idea is to locate quality businesses in an effort to reduce unforced errors. Again, one way to do this is to focus on valuation alone. I think Schloss implemented this method the best. Another way is to study compounders and be disciplined to only invest when the valuation aligns with your hurdle rate.

And in terms of percentages, there will likely be fewer errors made (fewer permanent capital losses) in the compounder category than there will be in the cigar butt category. It doesn’t mean one will do better than the other, as higher winning percentage doesn’t necessarily mean higher returns. But if you want to reduce unforced errors (reduce losing investments), it helps to get familiar with stable, predictable businesses with long histories of producing above average returns on invested capital. 

So circling back to the compounders… and the question of: “Yeah the last 10 years are great, but how do we find the winners for the next 10 years?” One possible place to look would be to glance at the same list that Fortune put together. I attempted to recreat the Fortune list in Morningstar based on the last 10 years (2004-2013). As I’ve mentioned before, I keep a few quality lists at Morningstar including:

  • Non-financial stocks that have grown revenues and maintained positive earnings for 10 consecutive years (81 stocks, less than 1% of the database)
  • Non-financial stocks that have produced positive free cash flow in each of the last 10 years (596 stocks, 6% of the database)
  • Stocks that have produced returns on equity of 15% or more in each of the last 10 years (143 stocks, or just over 1% of the database)

My attempt to recreate Fortune’s list will fall short, because I can’t easily determine the average ROE of these 143 businesses, but this list would be a good place to start looking. Many of these stocks have performed very well in the past 10 years, just from glancing at the list.

And it’s worth noting that this list is the previous 10 years, it doesn’t mean that these stocks will maintain their strong returns on equity over the next 10, although research shows that most strong businesses tend to remain strong over time (mean reversion plays much less a role than is commonly assumed).

So it might be worth checking out this list, and keeping it as a watchlist for quality companies that might become available at low prices at some time or another. Or use it as a list to go through one by one, learning about successful business models in the process.

Here is a look at the list of consistent ROE stocks sorted by lowest 25 P/E ratios:

High ROE Low PE

Here is a look at the same list of 143 stocks that have produced 15% ROE in each of the past 10 years, this time sorted by highest Returns on Assets:

High ROE High ROA

Remember, all of these firms have achieved at least 15% ROE in each of the past 10 years, something 99% of public companies failed to do. This list certainly contains stocks that aren’t undervalued (many are quite expensive), but it’s probably a good list to keep an eye on from time to time, as it certainly contains a healthy amount of businesses with compounding intrinsic values.

25 thoughts on “1987 Berkshire Letter and Buffett’s Thoughts on High ROE

  1. John – nice follow-up thoughts. It is rare to find a high ROIC company at a cheap price, especially today. But when both factors align, it is the “fat pitch” Buffett writes that one needs to be ready to hit. Until the high ROIC, cheap price companies in one’s circle of competence appear, what do you tend to do? Look for special situations, or low ROIC companies at less than asset value? Or do nothing and wait?

    1. Undertherocktocks, my investment philosophy basically could be generalized as first looking for high quality operating businesses with simple, predictable business models that produce high returns on capital at 10 times earnings. I secondarily look for other ideas, which I would refer to as special situations. I used to categorize this broad category more specifically, but I think it creates too much confusion when I discuss it on the site. The basic idea with this “other” category is that I’m still looking for gaps between price and value… here I’m looking at corporate events such as spinoffs, rights offerings, recaps, or just plain undervalued or hidden assets. These tend to be shorter term investments that get sold at fair value. The compounders are my favorite investments as the best ones continue to compound value for long periods of time.

  2. I have been thinking about ROE and valuation more seriously for the last couple of weeks as well, mainly stemming from re-reading Buffett’s article “How Inflation Swindles The Equity Investor”.

    I did a screen on Morningstar for companies that increased their OpMargin every year for the last decade, only 8 companies showed up. This led me to looking at Church & Dwight Co. Despite its apparent high valuation for a long time, its fundamentals continue improving and its stock has dominated the SP500.

    Another interesting name on the list is Shoprite Holdings, the South African firm (not the store in New Jersey). Seems to have some very strong fundamentals and has been deleveraging, but its stock ha been hammered as a result of the emerging market concerns.

  3. @Undertherockstocks:

    I like this Munger quote:

    “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

  4. excellent article! but i think i am different with you,john. looking for great business is not an easy task for me and these stocks often have high valuation. so i am a deep value investor.

    1. Thanks Lei. Yeah there are lots of nuances within the value investing discipline. I too like deeply discounted cheap or hidden assets, but yes, my favorite situation is a high quality compounder that will continue to produce significant value over long periods of time. But I–like you–am not comfortable extrapolating today’s results too far into the future, thus the reason I’m not willing to pay high multiples for what I consider to be a great business (even though truly great businesses with long term futures are undervalued even at very high multiples). It’s difficult to predict what will happen to businesses, so it helps to pay low prices, as that increases your margin of safety and mitigates qualitative analysis mistakes.

      Outside of finding quality compounders at low prices to normal earnings, I do look at plenty of “deep value” stuff, although as I’ve said in the past couple articles, it helps not to put each idea into a style box. We’re just looking for simple businesses or simple ideas that have an obvious and understandable gap between price and value. Sometimes they are cheap stocks that are left for dead, other times its possible to locate quality companies with excellent returns on capital at a price that gives you a high earnings yield now, which means you don’t have to pay much for the excellent economics and bright future. Either way, both styles can work well.

  5. I understand your approach with investing in compounders very easily.

    Can you explain the other investment category? There’s special situations (spinoffs, restructurings, net nets, bankruptcy, sum of the parts… in other words huge gaps in value) Are there any other areas where you look for big gaps of value other then your search for a strong compounder?

    I”m personally looking for a portfolio that will thrive in any economic environment since I’m quite bearish on the economy going forward. Companies like Coca Cola, Pepsi, Nestle, General Electric, and Kellogg come to mind.

    What I don’t understand is the other component. Can you explain the looking for “significant gap of value.” So you look for huge undervalued situations. Maybe they have a bunch of valuable real estate.. likelihood of good capital allocation from a poor business, or a net net with catalyst?

    It’s so broad… Do you focus on any particular thing?

    1. Hi Jalo,

      Good question, and it might take more explanation. But some short thoughts… I don’t really look for one category over the other. And I don’t get into the office thinking “okay let’s look at special situations today” or anything like that. After looking at my investments in hindsight, these are the two broad categories that I could place them in for better explanation… but I really don’t compartmentalize the research process. I’m just turning over rocks, spending a lot of time reading, and researching new ideas. Sometimes they are great businesses with great economics, other times they are plain cheap stocks with some sort of recognizable significant gap between price and the value to a private owner. I would group these cheap assets with other special situations simply because they tend to be shorter term investments by nature. Sometimes a cheap stock appreciates and gets sold in a year or two, whereas great compounders ideally stay in the portfolio for longer periods of time as they continually compound value for owners.

      But in both situations, I’m thinking much more about the entry price and value, and rarely do I think about exiting. I’m comfortable owning stocks for long periods of time. It’s just that special situations/asset plays tend to resolve themselves at some point, and if they aren’t compounding value at high rates, the opportunity cost of holding them increases over time as they appreciate, so they tend to get sold at fair value.

      Regarding the “significant gap” question… yes, I’m just looking for very large gaps. I am very patient, and very choosy when it comes to investments. My feeling is that too many investors fill their portfolios with mediocre ideas and modestly undervalued ideas, which means that those ideas have much lower margins of safety. They do this in the name of diversification, but I believe that it negatively impacts both safety and future returns.

      With net-nets, it might be different as it’s more of an insurance bet. But on a case by case situation, you need to identify the most obvious, most significantly undervalued situations in order to achieve large margins of safety and large future returns. As Pabrai says, “I’m not interested in a stock that trades at 10 that’s worth 14, or 16, or even 19”. He wants a minimum 50% discount. Ideally, we’re looking for these types of “gaps”. There is an art to valuing compounders, but I try to create conservative ideas for what the business will be doing in normal times at various points, and I decide what those normalized earnings are worth to me. The benefits to investing in quality compounders is that they are very forgiving. You can be wrong about the value estimate, but as long as the business is growing value, your risk of permanent loss is mitigated. And the other major difference between a compounder and a net-net or other stock with static (or eroding) intrinsic worth is that with the compounder, the values are a moving target. They are increasing each year, thus increasing your margin of safety in the event of a stagnant stock price. This is a very pleasant situation when you can find it.

      Also, I rarely am “bullish or bearish” on the economy. You may have a view, and many who are smarter than me might be able to act on a view, although it’s very tough to do for even the smartest economists. The companies you mentioned are outstanding mature companies, although they are in a stage of life where their intrinsic value is growing at unnexciting returns (probably 6-8% or so). My off the cuff opinion of most of the large quality firms like that is that your investment returns will equal those rates of value increases over time, and shareholders shouldn’t expect much more unless they can acquire those firms at significant discounts… but the firms you mentioned are certainly fortresses that will likely be quite safe over time.

  6. well John, I guess I am a chain smoker – I cant seem to give up my cigar butts! granted owning compounders, is a more ideal situation but a basket of cigar butts ( 10 or so) is just so appealing. even this past decade net nets trading 75% or more below NCAV beat the market by 5-10% ill have to check the numbers once I get home for exact quotes.

    like you I like cheap and good, but I also like extremely cheap. sometimes cheapness is the catalysis.

    great post as always my friend.

    1. Thanks Jonathan. Yeah the cheap stocks are always interesting. And again, I’ve talked a lot about quality lately, but we’re really just trying to find the largest gaps we can between price and value. And it has to be understandable. The cheap stocks are often the simplest and the most quantifiable, thus their attractiveness. I agree with that, and like Graham and Schloss taught us, it is a perfectly viable strategy.

  7. Hey John,

    Another amazing article! Always love reading the comments too as there are a lot of gems in there.

    I get the feeling you ‘coattail’ other successful investors. For those investors that run a fund above $100MM, how do you track freely what they bought/sold? I noticed Gurufocus.com does this for free on a delayed basis. But they do have a $300/year where it’s revealed on real time (90 day delayed still). Any resources would be helpful!

    1. Thanks for the comment. Yeah I like looking at what other investors are doing, as I get numerous ideas from them. I wouldn’t say I coattail though… I mainly use the 13-f’s as idea generators, and then do my own research on ideas that appear to be valuable.

      I really just use the SEC site to research the holdings. It’s free, and it’s easy to use. Alternatively, you can look at sites like Whale Wisdom, that aggregate the data for you to make it easy to view. I use that site, and also use GuruFocus, which also does an excellent job at summarizing the buying and selling of these “gurus”.

      I don’t spend much time trying to figure out who’s buying and selling what, though. I really just spend a few minutes each quarter going over the portfolios of a few value investors I respect, and occasionally I get something interesting.

  8. I think high RoE metric is a good starting point but totally irrelevant for future investment as its backward looking. Theoretically as long as RoE >Cost of equity the main value driver is future growth. So, if you a have a business with 100% RoE but with no future growth opportunities its franchise value is zero regardless of how high is the RoE .While some times a lower RoE business with say 15% RoE has big reinvestment growth opportunities and as result will have a much higher franchise value. This explains buffet focus on durability and consistency (CAP period)+Reinvestment opportunities. Because their relationship is multiplicative you need both factors in play.
    The problem is that future investment opportunities won’t appear in the company financial statements as buffet said before our best performing investments were made when the number did not support it. What I think buffet meant was that future growth opportunities for these companies are high and as result they have the ability to reinvest at high RoE for many years to come justify the purchase price that did not look cheap at that time. The challenge is that these future growth opportunities cannot be easily assessed quantitatively and needs deep industry knowledge, common sense, and deep understanding of the magic of compounding.

    1. Thanks for the comment… the simplest way to think about this is that a firm’s future ability to grow its value intrinsically is simply the product of two factors: the incremental ROIC and the reinvestment rate (how much can it retain from earnings to reinvest at that same ROIC). So a business that produces 20% incremental returns on capital that can reinvest 50% of its earnings at that rate will grow intrinsic value at a rate of 10% annually (50% times 20%). Likewise, a firm that produces 10% ROIC that can reinvest 100% of earnings will grow at 10% annually (100% x 10%). A business that makes 50% ROIC that can only reinvest 30% will grow at 15% annually, etc… Also, the firms with lower reinvestment rates but higher ROIC will likely create more value for shareholders (assuming the same intrinsic value growth rate) because it still has a large portion of its earnings to either buyback stock or make accretive acquisitions (or just pay dividends). Of course, they could destroy value as well…

      1. Thanks for your comment
        I think there is some confusion on terminologies here. Reinvestment opportunities is not the same as reinvestment rate.Many companies go for high reinvestment rate but few reinvestment opportunities and as result end up destroying value.

        1. Correct… as I say, a business’ “compounding rate” is a simple formula. It’s the product of its reinvestment rate (the amount of capital it reinvests each year) multiplied by the return it achieves on that capital (ROIC). A business’ intrinsic value will grow (or shrink) as a direct result of those two factors. As you correctly point out, if it reinvests money at low returns it will grow value at low levels (likely not exceeding its cost of capital, which will destroy value). Also, if a business doesn’t have reinvestment opportunities (0% reinvestment), it will not grow. In either case, capital allocation is a third component to the overall company value, as management can still grow value per share by prudent capital allocation.

          To simplify it, I wouldn’t differentiate between reinvestment opportunities and reinvestment rate. If a business reinvests 100% of its earnings then the reinvestment rate is 100%. As you say, maybe they destroy value by only achieving 4% returns on that investment. I think what you’re saying is that maybe management doesn’t have much opportunity to reinvest at high ROIC’s, and that’s often true.

          But the math is simple: the business will invest a certain amount of its earnings, and that is the reinvestment rate. That investment will produce a certain return, which is the incremental ROIC. The enterprise will compound at a rate that is the product of those two factors. And outside of the enterprise itself, the excess cash (earnings that can’t be reinvested into the business) can also create or destroy value.

  9. Hey guys,

    The US does seem like a very competitive market for this kind of value investing. There is a whole world of opportunities in emerging economies….there are outstanding companies which are under researched etc.

    For example, there is a company called “Hawkins Cookers” in India. Its basically up 12,000% over last 10 years. Hawkins Cookers are used in almost every single household in India no matter what the status of the family….whether low income, mid income or high income. Just a fabulous business but was undersearched and is up 12,000% !!

    Check it on googlefinance charts.

  10. Great Article John.
    Just a quick question – how do you determine the reinvestment rate as well as the incremental ROIC?

    1. Hi Vik,

      Each business is different with different working capital, fixed asset and capex needs, etc… so you really need to look at the annual report to get an understanding of how the investment needs of the business and how it uses its retained earnings. But there are some back of the envelope ways to look at it. The first thing you can do of course is check and see how much of the earnings are paid out as dividends, and simply assume the balance that is retained is reinvested (i.e. if the payout ratio is 40%, then the retained portion is 60%)… however, this doesn’t separate out what portion of earnings are invested into the business and what portion is used for acquisitions. Often times you can get a better handle by viewing the cash flow statements and determining what portion of earnings were used for acquisitions, and sometimes companies will disclose what level of capital they need for maintenance capex.

      Another back of the envelope way to determine incremental ROIC works well with stable, mature businesses. You can look back at the balance sheet for say 10 years ago, and determine how much capital the business had invested at that point. Then compare that to the capital invested today. Then, compare that increase in capital invested to the increase in earnings, and you have a rough proxy for the incremental returns that the business produced over that decade.

      For example, we could determine Walmart’s incremental ROIC by looking at its balance sheet from 2004 and identifying that WMT had a total of $63.7 billion of debt ($20.1b) and equity ($43.6) capital invested. In that year, it earned $9.1 billion, or a return of 20.9% on its year end equity level (ROE) and a 14.3% return on its debt and equity level (ROIC). Fast forward to today, and we see that Walmart has increased its invested capital to $120.8 billion ($76.3b of equity and $44.6b of debt), and it has increased its earnings to $16.0 billion. This means that in the last 10 years, Walmart has incrementally invested $57.1 billion of capital (i.e. its invested capital increased from $63.7 billion to $120.8 billion). From this $57.1 billion of additional investment, the company received $6.9 billion in incremental earnings (earnings grew to $16.0 billion from $9.1 billion 10 years ago). So this rough, back of the envelope estimate says that Walmart achieved a 12.1% return on incremental capital invested ($6.9b in earnings growth from $57.1b in additional capital invested).

      As for the reinvestment portion of the earnings, we can use an even more “back of the envelope” method to ballpark the reinvestment rate. We know that Walmart made $138.5 billion in total earnings over the last 10 years, and since it invested $57.1 billion of additional capital, we could say that it reinvested capital that equaled about 41% of its earnings. Of course, it’s possible that Walmart could retain a smaller portion of earnings if it took on more debt (which it did). We could look at the equity portion only and see that Walmart’s equity grew by $32.7 billion over that decade ($43.6b in 2004 to $76.3b in 2014). From this, we could say that Walmart needed to retain only 24% of its earnings ($32.7b of $138.5b), and the additional capital invested came from an increased level of debt. So it appears that Walmart can use a majority of its earnings to pay dividends and buyback shares, as it only required incremental capital that equaled around 41% its earnings. Of course, this is kind of a reverse way of trying to figure out the reinvestment rate… you could go back and look at any given year’s earnings and use the cash flow statement to determine how much of the earnings it spent on dividends and buybacks, and from there find out how much it retained to use for maintenance capital spending, growth, etc…

      To get a true handle on the reinvestment needs, you’ll need to look at the treasury shares (buybacks), the dividends paid out, the investment needs, etc… and combine those financials with a general understanding of the business (how does it operate? does it grow by acquisition, internal reinvestment, etc…)

      But very generally, using those two numbers (the reinvestment rate and the return on capital), you can determine the growth rate. If a business can retain 40% of its earnings and it gets a 12% return on that investment, earnings will grow at around 4.8% (12% x 40%). That type of growth rate is probably fairly reasonable to expect from Walmart. Of course, it can create additional value from the portion of earnings not reinvested by buying back shares and paying dividends.

      Again, this is a back of the envelope way to determine this at a quick glance. There are various ways to compute the denominator (i.e. “invested capital”) and there are a few ways to calculate the numerator (“return”). In this case, I just used net income for return, and the total equity and long term debt (including capital leases) for total invested capital. Depending on the nature of the business, you’ll need to make adjustments. Also, this type of back of the envelope analysis really only works for mature businesses that are stable in nature.

      Remember, the goal when calculating return on capital is to find out how good the business is at generating earnings from the capital it invests. I recently read a 10-K from a small retailer that invests an average of $200k to open a new store and within the first year sees a return of $300k in pretax earnings, or a pretax return of 150% on the cash it invests. Needless to say, that’s a great use of cash. Who knows how long the stores will produce 150% returns, and I have no idea about the durability or the long term viability of that concept, but that is a business that is doing very well by any measure. That’s what you’re trying to identify–a good business that can produce high returns from the capital it retains and reinvests back into the business. It’s what you’d like to see if you owned the entire business.

      1. John,
        Just wanted to say thank you for all of your posts and commentary. I have learned a ton just reading through your older posts and archives. I have been doing some of the back of the envelope calculations you detail nicely above and I have a question on how to calculate this for company with negative shareholder equity.

        My question is about PM Phillip Morris International. PM has been buying back very large chucks of stock (~28% of shares outstanding) since 2008 and as a result has negative shareholder equity. They also have been very shareholder friendly in regards to the dividend as it has increased over 100% since 2008.

        When I calculate ROIC I end up only getting ~3% when adding back the treasury stock. It seems I’m doing something wrong as I assume I am not treating the buybacks and dividends appropriately.

        Tobacco traditionally has been a very asset light business with excellent pricing power and obviously very shareholder friendly management. I would expect ROI would be much higher.

        Also as a corollary after reading through your website I have seen very little discussion about tobacco companies in general. I have always known them to be very shareholder friendly with excellent returns. They a certainly are not little obscure companies though where value is often found. Is there a particular reason for their admission or am I under an incorrect assumption about their returns?

        I think I have read a couple times that Buffett thought tobacco companies were fantastic business and investments and withheld investment only due to potential public scrutiny. Have you invested or look in detail into these companies?

        Looking forward to your response,

        Thanks

  11. Great article and discussion. I have always struggled with the concept of a changing intrinsic value. Above you refer to growing or shrinking intrinsic value. Are you referring to the assets and earnings of the business, rather than intrinsic value (what it is worth today to a private owner)? If intrinsic value is the discounted present value of the free cash flow of the business (including the cash generated by reinvestment and other capital allocation decisions), then surely it doesn’t change over time?

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