Wednesday, June 22, 2011

Charlie Munger: Two Kinds of Businesses - Part II

A follow up to this previous post.

With the following thought from Charlie Munger in mind...

"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."

...consider a typical automobile manufacturer.

Occasionally, though for some not very often*, an automaker will actually have some earnings. The problem is much (if not all of it) will go toward:
- helping fund the creation of the next generation vehicles, and
- absorbing the nearly certain future operating losses (during the next meaningful economic downturn).

In my view, you can't look at price to current earnings to gain any meaningful insight with most automobile manufacturers. In fact, if you look at many of the automakers over a few business cycles, there's not all that much in the way of normalized earnings. It's especially ugly for investors when viewed in the context of the amount of capital that is being employed to produce the rather meager (or nonexistent) earnings.

So what seem like earnings are, in fact, mostly illusory. Return on capital ends up being subpar or much worse. For many auto manufacturers, their earnings are a necessary and useful fuel for staying in the game. Yet, the last time I checked, effective investing doesn't involve putting capital at risk just so a business can survive while ultimately generating unsatisfactory or negative returns. (An FDIC insured bank account provides a much safer way to produce modest returns with essentially no risk of negative returns.) It's about getting much more out, commensurate with the risks taken, primarily through the increases of a businesses earning power per share over time.

It's pretty simple. A business that needs most (or all) of its earnings just to stay remain a viable going concern cannot produce satisfactory economic returns for investors.

Any automaker that invests insufficiently or ineffectively in the next generation of products has a high probability of being on the ropes once the inevitable next recession hits. It takes little time for the current generation of vehicle to lose competitiveness in the marketplace.

Still, even those that survive are not likely to produce much in the way of returns for shareholders. Let's say someone buys the following two stocks in the late 1950s and reinvests the dividends over the next fifty years.

$ 10,000 invested in General Motors (GM) stock in the late 1950s, even before it went bankrupt, had not produced much shareholder value fifty years later (considering the time frame). Of course, ultimately the stock was worth nothing. First of all, investors in an inherently weaker business like GM would have been better off if those dividends were not reinvested. Actually, considering the challenges (its capital intensiveness and brutal competition led to low return on capital and reduced business durability) that was facing an enterprise like General Motors, better to not invest at all.

In contrast, over the same fifty year period, $ 10,000 invested in Philip Morris/Altria (MO) grew to over $ 80 million (incl. reinvested dividends).

Philip Morris/Altria generated an annual return of nearly 20% during that time frame.

An asset that returns that much annually left to the magic of compounding turns $ 10,000 into $ 80 million in 50 years.

That means a roughly 6x increase in value has been a typical decade for MO. Some of this came about as a result of a consistently low stock price. The threat of legal liabilities and that some investors don't want anything to do with a business that sells tobacco products meant the shares were often cheap. The fact that it is a business with high return on capital and the dividends could be used to buy shares consistently cheap were key factors in generating high long-term returns. This works with buybacks as well even if the tax implications, depending on the type of account, are generally not the same

Excluding the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to intrinsic value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.

Odds are pretty good that both MO, and the spin-off Philip Morris International (PM), will continue to do just fine as investments though, I think it's fair to assume, they're not likely to generate anything close to those spectacular returns going forward.
(Now, if it turns out to be better than expected there'll surely be no complaints.)

In any case, all else equal, they'll be even better long-term investments if the shares consistently remain rather cheap.

Imagine having $ 10,000 laying around back in the 1950s and not being sure whether to make a long-term investment in GM or MO. I'm guessing most investors back then thought of GM as an unstoppable business juggernaut while MO was a company heading into uncertain legal liabilities and reduced demand for their products.

Occasionally, a well run automaker will do better than GM and maybe even make more than modest returns for investors. So theoretically there are exceptions.

The problem is you have to pick the right one.

Unfortunately, the right one in the auto industry will probably do worse for investors than a laggard in some other field. In certain industries, the leader will produce excellent return but even the laggards produce good results for investors.

The cereal business come to mind. More from Charlie Munger:

"If it's a pure commodity like airline seats, you can understand why no one makes any money....Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%."

It's easier to pick a needle out of a stack on needles.

Yet, the generally subpar long-term returns produced by automotive manufacturers are not simply the result of weak management. For an investor, I think the problem goes deeper than that. These are fundamentally difficult businesses with almost no chance of producing a high return on capital for investors. A well run auto manufacturer is, in most cases, just going to be the best house in a bad neighborhood.

So that mean, even with the best, an investor takes on more risk for lower returns versus many alternative investments.

Think about how much Ford (F), GM and other major automakers have had to spend on new car models over the past 30 years. Yet, even with all that money put to work, there is still no real moat protecting the future economics of these businesses. They are only as secure as the competitiveness of the next models that they produce. Underinvest or misfire on key new product launches and it won't take much time for any automaker to be in some trouble.

A good business that invests heavily in its future over time should also be able to build some kind of an economic moat. Something that protects the economics of a business for an extended period into the future against competition (some combination of brand strength, a cost advantage, broader distribution etc). Automakers have a very tough time doing this.

In contrast, how much has someone like Wrigley had to spend producing its next generation pack of gum over the past 30 years?

Here's how Munger looks at it:

"If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth which is a pretty personal place, after all for a lousy dime?"

So Wrigley has little difficulty charging something like 33% more in price for essentially the same product because of the trust and familiarity of the brand. What would an automaker have to put into one of it's machines to get a customer to pony up 33% more dollars. Yes, brand matters in the auto business but even the better ones would struggle to charge a higher price without more...more...more. More options, more horsepower, more engineering etc.

Meanwhile, Wrigley sells variations of gum and other candies, with updated packaging of some kind every now and then, and gets to charge a nice premium. I'm not saying that running Wrigley's well is easy. Yet, I'd bet if there was not a single update to that pack of gum over the next decade they'd still basically have a pretty good business.

That's the best evidence of Wrigley's moat. They'd still make a nice living even if they stopped innovating tomorrow (though they may miss a whole lot of upside).

Not true for automakers.

Some of this comes down to being a small ticket item instead of a big ticket item relative to an individual's average annual budget. If you are about to spend $ 100 on groceries no one is going to sweat ten cents more for the pack of gum that you like and trust.

Not so for a big ticket item like a car.

I realize producing automobiles for a living is probably a lot of fun but, from an investors point of view, which kind of business would you rather own?**

In lower quality businesses like automobile manufacturing, the problem is that the basic alternatives for management are unattractive:
-stay competitive by making the investments in new technology while producing lousy shareholder returns (not necessarily zero or negative, but certainly not great long-term relative to alternatives given the risks)
-do not make those investments, lose competitiveness, and watch earning power shrink over time (as competitors adopt the new technology) while producing even crappier returns

Durable competitive advantage, pricing power, and modest capital requirements are found among the better businesses. Selling a desirable small ticket item doesn't hurt.

Pretty much the opposite of almost all auto manufacturers.

The better businesses have earnings that are truly free to benefit shareholders (i.e. not continuously needed to shore up business competitiveness).

Earnings that are either available to be distributed to shareholders or can be used for incremental investments that ultimately produce even higher future returns for shareholders.

Investing is not about earning or earnings growth in a vacuum; it's about return on capital. What matters is the earnings that can be produced relative to the capital that is employed. Well, many high quality businesses -- those that produce terrific and durable returns on capital in their current form -- often have limited opportunities to deploy incremental capital at a high rate of return.***

Some businesses may be growing earnings fast but require the deployment of capital at an even faster rate. Investors may chase that sort of growth but simple arithmetic gets in the way of shareholder returns in the long run.
(It's another story for traders, of course.)

Return on capital mostly dictates long-term overall returns. An investor can't escape the long run gravitational force that causes returns to converge on what a business can generate in earnings relative to the capital employed. 

Bottom line: buy quality businesses at the right price and the rest should take care of itself over the long-term.

Adam

Long position in MO and PM

Related prior post:
Charlie Munger: Two Kinds of Businesses

* As an example, if you add up the earnings from each of the past ten years, Ford Motor Company's losses were more than $ 20 billion.
** I'm not making a judgment on the merits of trading any automaker's stock here. I am looking at how much intrinsic value a business creates in the long run. The stock may end up working just fine as a trading vehicle over a business cycle. I have no useful skills or opinions regarding that sort of thing.
*** Both incremental capital and ongoing capital that's needed to maintain or even improve the existing "machinery". In other words, the investments necessary to fortify the important existing physical and intangible assets already in place. Capital that at least maintains but ideally improves (widening the moat) a firm's competitive position. It's generally when incremental capital gets deployed at low returns, in the blind pursuit of growth, where long-term investors end up getting hurt.
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