Tuesday, March 29, 2011

Buffett: 57% Return on Equity Capital - Berkshire Shareholder Letter Highlights

Today, a long list of high return on capital businesses can be found among Berkshire's operating businesses (example: See's Candies) and in the equity portfolio things like:

Coca-Cola (KO),
Johnson & Johnson (JNJ), and
Procter & Gamble (PG).

In addition, the financial stocks in the portfolio like Wells Fargo (WFC) and American Express (AXP) are just about the highest return on equity capital businesses in the financial sector.

In the 1987 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett elaborates on the importance of high return on capital:

"...our seven largest non-financial units: Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See's Candies, and World Book. In 1987, these seven business units had combined operating earnings before interest and taxes of $180 million.

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. Debt plays an insignificant role at our seven units: Their net interest expense in 1987 was only $2 million. Thus, pre-tax earnings on the equity capital employed by these businesses amounted to $178 million. And this equity - again on an historical-cost basis - was only $175 million.

If these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million - a return of about 57% on equity capital. You'll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage. Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade."

Today, there are many low return on capital businesses selling for what seem to be reasonable prices but probably not as cheap as they seem:

"If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994

Buffett continues in the letter...

"Of course, the returns that Berkshire earns from these seven units are not as high as their underlying returns because, in aggregate, we bought the businesses at a substantial premium to underlying equity capital. Overall, these operations are carried on our books at about $222 million above the historical accounting values of the underlying assets."

So a business will sometimes seem a bit expensive. Yet, if that business has durable high return on capital a good result over the long haul is likely to occur.

Margin of safety remains important but the point being that purchasing a low return on capital business at what seems like a "cheap" price is no bargain.

To be continued in a follow up.

Adam

Long positions in all stocks mentioned
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