Importance of ROIC Part 3: Compounding and Reinvestment

Posted on Posted in Education, Investment Philosophy, Investment Quotes

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”

-Charlie Munger, 2008 Berkshire Hathaway Annual Meeting

I’m patiently looking for bargains everywhere. That’s the name of this game: “figuring out what something is worth and paying a lot less for it,” as Joel Greenblatt says. But everyone wants to be more specific… Ideally, what I like to invest in are compounders. What are compounders? Very simply, they are high quality businesses that can grow their intrinsic value at high rates of return over long periods of time. A business that can grow intrinsic value at say 12-15% over an extended period of time will create enormous wealth for its owners over time, regardless of what the economy does, or what the stock market does, or what earnings multiples do , etc…

I like a business that produces high returns on capital and consistent free cash flow. Like Charlie Munger says, we want to find businesses that can write us a check at the end of the year. I love this simple explanation, and it’s one that I always keep in mind, and it’s a good starting point—a conservatively financed business that can write you a check every year (i.e. produce more cash from operations than it needs to maintain its current competitive position) is unlikely to get you into trouble. That’s why I like keeping a list of businesses that have produced 10 consecutive years of free cash flow.

Cash Flow is Nice, Reinvestment Opportunities Are Better

I love the business Munger talks about that cuts me a check every year from its consistent and stable cash flow. But ideally, I’m looking for businesses that will forego sending me a check because of the attractive reinvestment opportunities that it has within the business itself. In other words, I would prefer a business that not only produces high returns on invested capital, but can also reinvest a large portion of its earnings at similar high returns. This is where a business achieves the true compounding power. Typically, these compounders enjoy a niche or some kind of competitive advantage that allows them to achieve consistent high returns on capital.

So it’s really nothing different from what most other investors and business owners want: quality businesses that will produce high returns on invested capital with attractive opportunities to reinvest earnings, which leads to value creation (higher earnings over time).

This gets discussed often, and the variables involved with businesses achieving this type of compounding power are sometimes difficult to ascertain and even harder to predict going forward. But the math is quite simple: A business’ compounding power can be calculated by three simple factors:

  • The percentage of earnings that a business can reinvest back into the business
  • The return that the business can achieve on this investment
  • What the business does with excess cash flow (if the reinvestment rate is less than 100%)

So ideally, we want a business that produces high returns on capital and can retain large portions of its earnings to reinvest at similar high rates of return. If there is excess cash flow that can’t be reinvested, I’m looking for logical capital allocation that might result in dividends, buybacks, or value accretive acquisitions (which are rare).

The Math of Intrinsic Value Compounding

I recently read something that used some examples to illustrate this compounding formula. Basically, the compounding effect is the product of the first two factors: return on capital and the reinvestment rate. If a business can achieve 20% incremental returns on capital and it can reinvest 50% of its earnings each year, the intrinsic value of the business will compound by 10% annually (20% x 50%).

Similarly, a business that can reinvest 100% of its earnings at 10% returns will see the value of its enterprise also compound at 10% annually (100% x 10%). Note: the first business is better because the higher ROIC and lower reinvestment rate means that 50% of the earnings can be used for either buybacks or dividends (or value creating investments).

ROIC is the Most Important Factor

But it’s crucial to understand the math… the math suggests that return on capital is the most important factor. A business that produces 6% returns on capital is simply not going to compound its owners’ value at attractive rates, regardless of how much or how little it can reinvest. But a business that produces 30% returns on capital will likely see the intrinsic value of its enterprise increase at high rates of return (even if it can only reinvest half of its earnings, the enterprise itself will grow at 15% annually, and the company will be able to create additional value by buying back shares or issuing dividends with the other half of the earnings).

So this hopefully illustrates why return on capital is such an important concept and why Buffett, Greenblatt, and even Graham often discussed it.

The key question is what to pay for a business like this. We haven’t discussed valuation. Ideally, I’m looking to be opportunistic with my investments, meaning that even with what I consider to be great businesses, I want to buy them cheaply because it dramatically increases the margin of safety in the event that you made an error in your analysis.

In other words, we want to locate quality businesses with high returns on capital, but we want to pay low price relative to the earning power of these businesses, as this gives us two things:

  • A margin of safety if we were wrong about the quality or sustainability of the business’ return on capital
  • The benefit of much higher returns if we were in fact right about the business

Heads, we win. Tails, we don’t lose much…

Some investors say that they don’t care about quality, only valuation. This has been shown to be true in various backtests, although most of the tests are short term in nature (usually 1-2 years). I think there are serious flaws in the logic of abandoning quality—and serious risks as a result. After all, quality, like growth, is a part of valuation. Too many investors get caught up in the simple metrics and assume that quality in mutually exclusive from valuation. It’s very much inclusive…

But that aside, it’s fairly logical that we would prefer—as business owners—to own quality businesses over mediocre businesses—valuations being equal.

How Much To Pay?

The question is what price to pay, and my general answer is that it depends on the business and the specific investment. I try to imagine what the business and its normal earning power would be worth to a private owner. I really look at each investment on its own–not as part of a larger portfolio. Each investment has to stand on its own.

When it comes to valuation, I’ve heard some people say that for quality businesses, they don’t want to pay more than an average valuation of around say a 6-7% normal cash earnings yield (the so called “good business at a fair price”). I don’t really use this type of thinking, but I think a 10% pretax earnings yield (something Buffett uses as a rule of thumb) is a fair guidepost for a quality business that is growing. This isn’t cheap, I know. It’s why I think of each investment differently. Graham had earnings multiple rules of thumb, Buffett has his rules of thumb, and I think they might be helpful in ensuring that you don’t overpay for what looks like a great business. But keep in mind those are rules of thumb. Some businesses are worth more. Most are worth less.

Think About Durability of Earning Power

As I’ll show in another post, the math behind choosing the “right business” is very compelling—it’s far more important to invest in the right business than it is to worry about whether to pay 10x or 12x or 14x earnings. It’s just that paying a low price protects us from our errors. The problem most investors have is that they are good at paying low prices, but bad at determining whether this low price corresponds to a large gap between price and value. There are lots of mediocre businesses available at 10x earnings, which will lead to mediocre results over time for long term owners.

The quality, the durability, and the earning power of a business are very important factors in assessing the margin of safety of the investment. Every bit as important as determining the normal earnings yield.

Compounders vs. “Special Situations”

Quality businesses will create more value for owners than mediocre businesses (groundbreaking news, I know…). So as a long term owner, I’d much prefer the former over the latter, almost regardless of how cheap the latter gets. A business that is shrinking its intrinsic value means that time is your enemy–you must sell as soon as you can because the longer you hold it, the lower the intrinsic value becomes.

But, flipping stocks might be a different story… it’s possible to buy a bad business at 8x earnings and sell it at 12x, yielding a nice 50% return. However, I find it much more comfortable and suitable to my personality to be able to garner investment results that correspond to the internal results of the business, as this eliminates the need to be right about timing, and it eliminates the need to constantly be producing good investment ideas—which is a difficult task to begin with.

In short, I like having my stocks do the work for me.

Of course, this is ideal, and not everything is ideal, and it leads me to a secondary category of investments, which I’ll group together as “Special Situations”… a category that includes these cheap stocks that can be sold at a profit to a private owner. This subset of investments also includes sum of the parts ideas, cheap/hidden assets, corporate situations such as spinoffs, rights offerings, recapitalizations, tender offers, etc…

The difference between these two categories can be summarized using an analogy of the dairy farmer (who raises dairy cattle to produce consistent milk over time) vs. a cattle rancher (who raises beef cattle which are used for meat production). The dairy cow provides consistent milk over and over for long periods of time. The beef cow doesn’t produce cash flow, but provides a payoff when the beef gets sold.

The compounders are the investments that continually grow intrinsic value over long periods of time with corresponding shareholder results over time. The investor buys compounding machines to partner in a business as a part owner, reaping his or her rewards over time as the business compounds in value. There is not an exit strategy in mind at the time of purchase with these types of businesses. It doesn’t mean they get held forever, but the idea is to compound your investment over long periods of time through the business’s results. The special situations are investments which are bought to be sold to someone else at a higher price.

But even in these “special situation” investments, I tend to keep in mind the same general business principles discussed above. Each investment is unique, but the principles are generally the same.

To Sum It Up

I look at a lot of undervalued situations and various opportunities, but I prefer investing for the long term—partnering with good management who are owner operators of high quality businesses with high returns on capital and attractive reinvestment opportunities.

The math is simple, and it exemplifies the importance of owning a business that can reinvest earnings at high rates of return—a situation that will create a compounding intrinsic value over time.

Some Other Posts in This ROIC Series:

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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.

20 thoughts on “Importance of ROIC Part 3: Compounding and Reinvestment

    1. Hi Henry, I think Markel (a position of mine) is currently quite fairly priced. I don’t talk often about positions I own though… Markel is one that I’ve written up. I try to stay away from recommending specific stocks in settings like this. Only if I’ve spent time writing about it will I discuss it. I may writeup a few others as I find time.

      1. The other “mini-Berkshire” Leucadia National is also priced at a discount to book right now. It compounds book value nicely but the benefits haven’t flowed through to earnings for a while, and there will be a new CEO — both of these might explain the discount.

        1. Yep, Leucadia has always had a different investment criteria than Berkshire has used. Still value, but they are willing to go into businesses without the “moats” that Berkshire likes. But value works, and it has worked well over the years. It will be interesting to see how the transition progresses for them.

  1. Compounders are indeed worthy companies to look at, but I think you’re looking at the wrong variable. ROIC can be useful with certain businesses, but ROE is the more versatile measure of returns on shareholder capital. After all, you start off talking about how it’s important how well management reinvests free cash flow (which counts as equity capital).

    ROIC does not work well when comparing leveraged (ie. financial firms). Even Buffett’s favorite Wells Fargo seems to be a poor yielder when looking at ROIC. When you look at ROE however, you can see Wells’ compounding power represented. ROIC also does not work for firms with financial/leasing divisions (ie DE, GE, etc).

    Obviously when looking at ROE, you need to account for leverage and judge if it’s appropriate for the firm.

    1. Correct… ROE is simply the return on the equity capital whereas most ROIC measurements include both equity and debt. But each business is different. The general idea for any business is to determine the returns that the business achieves on the capital it invests. The return on capital concept for banks still applies, but as you say most would use ROE to determine the compounding power. ROA is probably the best measure of the quality of a bank however, as it eliminates the leverage in apples to apples comparisons.

      But each company is different. Use the concept to help you determine the quality of the business by thinking in terms of return on investment. The specific calculation will vary depending on the type of business it is.

      1. Hi John, Great posts on intrinsic value growth of a company (ROIC x retention rate). I would like to know, if i am evaluating an NBFC or a bank. will the intrinsic value growth of NBFC/Banks will be ROE x retention rate? If I have understood wrongly, pls explain.

        1. Hi Alok,

          Yes same concept for banks. Basically, you’re trying to understand what kinds of returns a company can generate on its capital. For banks, I would look at the equity capital and determine the amount of earnings the bank retains and the amount of dividends it pays out over a period of time, which will give you a back of the envelope method to calculate the growth in intrinsic value, or in this case book value. In other words, a bank that produces 12% ROE that is retaining half of its earnings and paying out the other half in dividends, will compound its net worth at around 6% annually.

  2. I would be interested in any discussion on how incentives work out in these compounding companies, which are often pretty big and with diverse ownership by the time they can be identified.

    If you haven’t read it I would also be interested in what you think of The Outsiders book. Bill Ackman said it is “[O]ne of the most important investment books I have ever read.”

  3. Great post as always John.

    Besides the math that you layout, which is very powerful, the great thing with high ROIC companies (IMO) is that they can screw up a lot and still do fine. But if you have a very capital intensive business like the automakers or precious metal miners they don’t have a much room for error. In other words the high CAPEX business needs to execute perfectly to do fine/well.

    IMO high ROIC companies in general have a margin of safety built into the business. So if your able to purchase a high ROIC business with a margin of safety in the valuation you have two things going for you which is nice.

    Of course this is in general and there are always exceptions.

    Chris

    1. Great point Chris. I often think the same about variable cost structures and high operating margins. I like looking for room for the business to make mistakes and still be able to produce free cash flow.

  4. I definitely have started to think of a margin of safety as not only being the cheapness of the company but also in terms of quality, growth, timeliness (an investor should favor high annualized returns and liquidity in investments) and control an investor could have in an investment.

  5. There are so many ways to measure ROIC-be it ROC,ROCE ect.

    When you look for stats on ROIC is there a website you look at?

    What sources do you consider for an accurate reading on ROIC?

    1. Hi Judson, I calculate the returns on capital for each business individually. I think you can use screeners for rough estimates by using ROA, but each business is different… different capital requirements, different working capital needs, etc… so I try to look at each business and try to determine the cash on cash return that the business generates.

  6. Hello John

    Great post

    Can you please explain on how to define how much working capital the company needs, do we compare it against total assets?

    Or any other ways we can have a rough guide on how much working capital the company needs

    Thank you 🙂

    1. Hi Nithi,

      I unfortunately don’t have a rule of thumb that I use to determine working capital requirements, capex requirements, fixed assets, etc… Every business is unique, and these capital needs vary widely from industry to industry. Some businesses need an enormous amount of working capital to operate, and others need none at all. Some business operate with negative working capital–WMT is one example; the terms it gets on its payables for example act as a form of float for the business, allowing it to redirect capital into other parts of the business… for many businesses this scenario isn’t possible, but because of Walmart’s huge scale and buying power, it can take advantage of this negative working capital situation, which is somewhat akin to a short term interest free loan. So each business needs to be evaluated within the context of its own operating environment and its own specific industry to determine how much capital it needs to keep on hand.

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