Importance of ROIC Part 3: Compounding and Reinvestment by John Huber, Base Hit Investing
“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