In response to a recent Warren Buffett post about his thoughts on ROIC involving a See’s Candy example, a reader suggested I look at the Berkshire 2007 shareholder letter. It makes the same points but also offers some different slants on ROIC that are worth reviewing. I remember reading the 2007 letter when it came out, and I’m not sure why I didn’t think of it when I wrote the original post. Maybe I blocked it out, in the same way that I can’t remember lots of things that happened during The Great Financial Crisis!
The thinking behind capital productivity is a lot more important than the ROIC formula for investors. So while there’s a lot about the ROIC calculation and the many different versions of the ROIC formula on this blog, the conceptual aspects of the analysis – which is what Buffett is getting at in this letter – deserve a lot of attention and thought. You can’t get enough of it, so here goes with the 2007 Berkshire Hathaway Shareholder Letter:
Buffett ROIC Insights: The Good, The Great, & The Gruesome
The part of the letter that is relevant for this post is the section entitled “Businesses – The Great, the Good and the Gruesome.”
In that section Buffett breaks businesses into 3 buckets based on their desirability as investments. Here are the three categories:
Great – The business earns enduring high returns on capital
Good – The business earns high return on capital but also requires meaningful and recurring capital investment to sustain the returns
Gruesome – The business consumes lots of capital with no returns, or returns that don’t justify the investment
For each bucket, I have directly quoted from the letter and added comments in brackets:
[A Brief Intro]
“Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid. Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases. It’s better to have a partial interest in the Hope Diamond than to own all of a rhinestone.“
Great
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.
Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed. Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.
Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings. At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.)
Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire. We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital.
Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business.
In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.) There aren’t many See’s in Corporate America.”
[I find it interesting that Buffett says that growth is not necessarily a criterion of a Great business, yet the example he gives, See’s, actually has grown sales tremendously. There’s a lot out there from Buffett and others about “compounders,” or businesses that earn high ROIC but also have lots of opportunities to invest capital on incremental growth opportunities through large and expanding market opportunities, new product categories, or acquisitions.
That does seem to be what See’s was/is but Buffett isn’t talking about that. He’s saying he’s happy to take enduring profits from Great businesses that don’t grow or grow very little and invest them into other businesses. I am pretty sure that Jeff Bezos read a lot of Buffett, and I find it interesting that his definition of a “dreamy” business does seem to include incremental returns on invested capital, or growth via a large market opportunity:
“A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.”]
I guess that’s the difference between Amazon and Berkshire Hathaway!
Good
“Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation.
It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google. One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million.
But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.
Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.”
[Once again Buffett refers to how Microsoft and Google grow without lots of capital investment. But there is still lots of money to be made with businesses like FlightSafety, or many utilities, which can’t do that. In these cases, if the income stream is highly reliable and keeps pace inflation, the business can still be a good investment if the returns on capital are still comfortably above the cost of capital (though not necessarily stellar like the tech examples Buffett’ gives) and the price paid means the risk-adjusted returns are attractive for that investor.]
Gruesome
“Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.”
[One of the most valuable aspects of using an ROIC framework for investing might not be what investments it reveals, but rather the investments it informs us to avoid, and that is Buffett’s point here. It’s easy to be seduced by great stories about businesses and their potential, but if the returns simply don’t materialize or seem unlikely to in the future, it’s not a good investment at any price. ROIC brings discipline to the process, which hopefully helps prevents big losers.]
[Conclusion]
“To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”
[I love the savings account analogy. One would be hard-pressed to find many people who actually think about stocks this way, which explains why many people don’t have much success in the stock market over time.]