Tuesday, June 21, 2011

Charlie Munger: Two Kinds of Businesses

Some businesses must utilize almost all of its earnings (or what seems like earnings) just to remain competitive.

To some extent, this was covered in my previous post.

Airlines and automakers come to mind as good examples.

Those businesses tend to have earnings more in an accounting sense but less so in a real economic sense.
(If earnings need to be reinvested in the asset just to survive, they can hardly be considered useful economically to owners. It's the investment equivalent of running to stay in place.)

The very best investments require modest amounts of capital to deliver a steady or increasing stream of excess cash. If most, or all, of the cash earned needs to be plowed back into a business just to remain competitive, shareholders cannot do well in the long run.

Investing is about buying an asset at a price that allows the excess cash produced to provide a sufficient return considering the risks being taken and the total capital that's employed (over the full life cycle of the investment).

Businesses like Pepsi (PEP), Heinz (HNZ), Johnson & Johnson (JNJ), and Kellogg (K) among others generally produce lots of excess cash earnings that can be distributed to shareholders or used for incremental investments that ultimately benefit shareholders at a later time.

Each needs modest capital to remain competitive.

Each requires little in the way of capital relative to the cash produced.

At least that's been the case historically. The question is, as always, whether that'll change. In the previous post I mentioned the following quote by Charlie Munger:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

Pepsi, of course, is an example the first kind of business while things like airlines generally represent the second kind.*

Here is another variation of this idea that Munger presented during this 1994 talk at USC:

"The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.

For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, 'They've invented a new loom that we think will do twice as much work as our old ones.'

And Warren said, 'Gee, I hope this doesn't work because if it does, I'm going to close the mill.' And he meant it.

What was he thinking? He was thinking, 'It's a lousy business. We're earning substandard returns and keeping it open just to be nice to the elderly workers. But we're not going to put huge amounts of new capital into a lousy business.'

And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.

That's such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that's still going to be lousy. The money still won't come to you. All of the advantages from great improvements are going to flow through to the customers."

So, once again, what seems like earnings is actually of the poor quality variety. Those earnings are an illusion. They are there up until the point that shareholders would like to benefit from them.

The earnings exist, for the most part, in an accounting sense only. They are effectively good 'til needed by the owners, I guess. Like a fruit that's rotten before it is even ripe.

The result?

Earnings that are not available as dividends (or buybacks).

Earnings that cannot be used to fund future investments that will produce an attractive return.

Why? They mostly get used up just keeping the existing business alive.

Running in place.


Long PEP and JNJ

Related post:
Charlie Munger: Two Kinds of Businesses - Part II (follow-up)

* Pepsi is just one good example among many. It is both able to pay cash dividends to shareholders, make investments in new products, distribution etc. at a high rate of return to produce future streams of cash, while remaining competitive in its existing business. Favorable returns can also come from something like See's Candies: a business that has little need for capital yet reliably produces a growing stream of cash. If See's were a separate public company, a nice dividend, buyback (if shares were cheap enough), or smart acquisitions would be in order since there aren't many high return investment opportunities within the business. In other words, the incremental capital that can be put to work internally is limited (even if the capital that it does employ generates very attractive returns). So the excess capital needs to be intelligently redeployed by competent management.
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