Wednesday, February 22, 2012

Buffett on Productive Assets: Businesses, Farms, & Real Estate

More from a column recently written by Warren Buffett in Fortune.

Warren Buffett: Why stocks beat gold and bonds

In the column, which is an adaptation from his upcoming shareholder letter, Buffett talks about what he describes as the three major categories of investments. The first two categories were currency-based investments  and nonproductive assets like gold.

Here's the third major category.

Category III: Productive Assets

Buffett calls the 1) ability to maintain "purchasing-power value" and 2) requiring minimal new capital investment the "double-barreled test". What meets that test?

According to Buffett:

- Businesses -- or partial ownership of businesses via marketable stocks -- like Coca-Cola (KO), IBM (IBM), and See's Candies
- Farms
- Real Estate

Other businesses, like regulated utilities, fail the test because of  heavy capital requirements. Yet Buffett adds they will still likely be better than nonproductive assets and currency-based assets.

"Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See's peanut brittle."

The best businesses pass the "double-barreled test". While it's certainly smart to buy shares of those kinds of businesses cheap, the fact that durable superior economics are in place is more important than an extremely low initial purchase price.

"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

That's not an invitation to overpay. Margin of safety still matters a whole lot as protection against the unforeseeable. It's just that, when an investor has strong conviction that a business can earn high return on capital for a very long time, it allows for greater flexibility to pay a somewhat higher price.

So, while it's always smart to buy with the largest margin of safety possible, sustained high return on capital over two or three decades eventually can make an initially somewhat expensive looking price make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business.*

Not all capital intensive businesses are lousy but some earn a very low return on their capital.  Businesses like that, even if shares are selling at a low multiple of earnings, aren't actually the bargain they initially seem to be (though some of the better ones will still beat nonproductive or currency-based assets). They can be owned until what seems a near term valuation gap closes but, over a longer investing horizon, results will ultimately be influenced most by the low return on capital.

In the article, Buffett goes on to say that Berkshire will continue to own entire businesses and be part owners of businesses via shares of stock:

"Berkshire's goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety -- but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest."

The thinking that shares of a good business, especially if bought at a reasonable valuation, is somehow more risky than cash is flawed.

Check out the full Fortune Magazine column for Buffett's thoughts on the other two major investment categories.


Related posts:
-Buffett: Why Stocks Beat Gold
-Buffett: Why Stocks Beat Bonds
-Buffett on Gold, Farms, and Businesses
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Edison on Gold: Fictitious Value & Superstition
-Munger on Buying Gold
-Thomas Edison on Gold
-Grantham on Gold: The "Faith-based Metal"
-Buffett: Forget Gold, Buy Stocks
-Gold vs Productive Assets
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Grantham: Gold is "Last Refuge of the Desperate"
-Friends & Romans
-Why Buffett's Not a Big Fan of Gold
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* I consider this very different from paying a very high multiple for some newer, unproven, but fast-growing business where it's hard to foresee what will happen in three years never mind three decades.

CNBC - Warren Buffett: Stocks Will Outperform Gold and Bonds...and They're Safer 'By Far'

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