From this talk given this past May by Tom Russo, at the 8th Annual Value Investor Conference in Omaha, just before the annual shareholder meeting of Berkshire Hathaway:
I'm going to talk about value investing and my goal is what is simply described as buying fifty-cent dollar bills. But I recognize a couple of things that Warren Buffett spoke to our business school class at Stanford Business School in 1982 that affect how I apply that that notion of the 50-cent dollar bill. And the first important point was that the government only gives you one break as an investor and that's the non-taxation of unrealized gains and so you should probably build your investment practice in a way that you capture the benefit of that, which means you want to buy and hold for a very long time. And so if you just buy a fifty cent dollar bill and it doesn't grow in value, your return is entirely dependent on when that discount closes and so if it closes quickly in the first year, you might make a 100 percent on your money, but if it takes 10 years for that discount to close it will be a 7 percent return and if it takes 20 years it will be a three and a half percent return.
Now the offset of that is if you find businesses that are undervalued but have the capacity for that dollar to grow, you're much better off.
Dollar bills that grow with a high rate of return come in the form of a durable business franchise able to put capital to work at a nice rate of return over a long time frame:
...the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. - Warren Buffett
Of course, for many durable high return business franchises the need for capital is rather modest. In those cases, having management in place that knows to (and is disciplined about) returning the excess capital to shareholders is key*.
Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases. - Warren Buffett
If not returned in some form (dividends or stock repurchases), the capital often ends up getting chewed up in the form of wasteful low return projects and acquisitions that may grow the footprint of the "empire" but do little to fatten shareholder returns.
Check out the full transcript of Tom Russo's talk at GuruFocus.
* This doesn't necessarily apply to high-return businesses in fast changing industries, under constant competitive threat. What seems like high-returns now can disappear fast. Nor does it necessarily apply to, as we've seen in many cases, highly leveraged financial institutions. Otherwise, excess capital that cannot be put to high-return use invites all kinds of of potential for operational sloppiness (ie. sub-par quality, service, or something more subtle like carrying excess inventory due to poor working capital management practices). In other words, operations that end up undisciplined but little penalty is felt (at least in the near term) because of the inherent strengths or advantages of a franchise. That situation encourages the waste of shareholder wealth and most likely reduces competitiveness. Much better that it be returned to owners.
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