I am glad you brought the below statement to this discussion.
“The ideal business to invest in is one - where we can continue to invest large sums of capital - at high rates of return - for a long period of time.”
Incidentally me and my friends had a long discussion on the exact above statement couple of months back. What triggered the discussion was the below couple of paragraphs which appeared in a book called “Quantitative value”. I am reproducing those particular paragraphs here for the benefit of readers - mainly for new investors (I am sure seniors understand the below well)
The importance of high returns on capital is fully revealed when we think about reinvestment and business growth. Businesses must constantly reinvest capital to maintain existing production capability. If the business’s return on invested capital is lower than the rate of return otherwise available in the market, the reinvestment of capital into the business destroys value. Each dollar reinvested at a rate of return on invested capital below market rates of return translates into less than a dollar of market value. Let’s return to the example of See’s Candies, and examine it in the light of returns on invested capital.
Buffett bought See’s Candies in 1972 for $25 million. Its annual sales at the time of purchase were $30 million, and pretax earnings were less than $5 million. See’s Candies required just $8 million in invested capital to generate those earnings. This equates to a return on invested capital of 60 percent, which is an extraordinarily high return. We can assume that Buffett believed the returns were sustainable, which must have indicated to Buffett that See’s possessed a franchise. If the prevailing market return at the time was around 11 percent, Buffett may have estimated the intrinsic value of See’s at approximately 5.45 times (60 percent / 11 percent = 5.45) its invested capital of $8 million, or approximately $45 million (5.45 × $8 million = $45 million). At a purchase price of $25 million, Buffett paid only slightly more than 3 times ($25 million / $8 million = 3.125) invested capital, or about 56 percent of See’s Candies’ intrinsic value ($25 million / $45 million = 55.56 percent). Viewed in this light, See’s Candies was a steal at $25 million. Buffett, however, not yet fully appreciating the value of a franchise, was ready to walk away if the vendors would not accept $25 million. The vendor was asking $30 million, but Buffett was adamant about not going above $25 million. Fortunately for Buffett, the vendor caved.
In his 1983 Shareholder Letter, Buffett undertook the following thought experiment: Consider a hypothetical ordinary business that, like See’s Candies, also earned $5 million pretax, but required $45 million in invested capital, rather than See’s Candies’ $8 million. An ordinary business earning only 11 percent on invested capital would be unlikely to possess a franchise. A low-return business might be worth the value of its invested capital, or $45 million, which is the same value as See’s Candies. However, See’s Candies is the better business to own.
The value of its high returns on invested capital is best understood if we consider what happens if both businesses maintain the same unit sales in a world of persistent inflation. Imagine the effect that inflation has on the two businesses. A relatively low inflation rate of 2 percent steals half of our purchasing power over 35 years. Both businesses must double earnings to $10 million to keep up with this inflation. How can they achieve this? Given that unit volume remains flat, they must double the price of the product. Assuming profit margins remain unchanged, if we double the price, profits will also double.
Each business is also subject to input higher prices, and this will result in both businesses doubling their assets, since that is the economic burden imposed on business by inflation. A doubling of dollar sales means a proportionate increase in working capital, and fixed assets. This inflation-induced investment produces no improvement in rate of return. The motivation for this investment is maintenance, not growth. Remember, however, that See’s had invested capital of only $8 million, so it need only commit an additional $8 million to finance the capital expenditure imposed by inflation. The hypothetical ordinary business has a burden over five times as large—and therefore needs $45 million of additional capital.
Thirty-five years later, the ordinary business, now earning $10 million annually, is probably still worth the value of its tangible assets, or $90 million. This means that its owners have gained only a dollar of nominal value for every new dollar invested. See’s Candies, also earning $10 million, might also be worth $90 million if valued on the same basis as it was at the time of Buffett’s purchase. So it would have gained $45 million in intrinsic value while the owners reinvested only $8 million in additional capital, which equates to over $5 of nominal value gained for each $1 invested.
What actually happened to See’s Candies? Thirty-five years after it was purchased, See’s Candies’ pretax profits were $82 million. By 2007, the capital required to run the business was just $40 million. This means Buffett had to reinvest only $32 million over 35 years to fund the growth of the business. In the intervening period, pretax earnings totaled $1.35 billion. All of those earnings, excluding the $32 million reinvested in the business, were sent back to Buffett, which he was able to use to buy other businesses and grow Berkshire Hathaway. More than 97 percent of See’s Candies’ return was paid out to Buffett, yet the business grew at more than 7.5 percent a year for 35 years (and to think that the acquisition nearly fell over for want of $5 million). If the vendor had stuck to his guns and demanded $30 million, Buffett might have balked, and that $1.35 billion would have gone to somebody else.
From the above example, one can see how a high ROCE business can throw out huge amounts of cash if it maintains its competitive advantage for long periods of time. In Sees Candy’s case, the Brand is its competitive advantage as it is considered premium but only in the US West Coast (mainly around California). So, Buffet didn’t expand Sees business in other parts of US (just for the sake of growth) because the Brand isn’t considered premium and hence it wouldn’t earn high ROCE. Being the master capital allocator that he is, Buffet did minimal expansion of Sees business and took most of the cash out to invest in other high ROCE businesses. We, individual investors can learn from the above. We need to find high ROCE businesses which can maintain it for long periods of time. Next, we need to also check if the business can continue to reinvest the incremental capital it generates (read as cash profits generated in the previous years) at high ROCE too. If yes, we remain invested. If not, we sell the stock and reinvest in another company which has high ROCE and can reinvest incremental capital at high ROCE for many years forward(we don’t have the benefit like Buffet to continue owning the high ROCE business and just take out the profits generated).
Also do note the quick back-of-the-hand way of calculating the intrinsic value of the business. Other things to remember are - competitive advantage is not permanent and it will erode over long periods of time due to competition. But some companies do manage to hold on to them for long periods of time.