Tuesday, May 10, 2016

Buffett: The "Double-Barrel Effect"

Here's what Warren Buffett and Charlie Munger had to say about the necessity to buy more capital-intensive businesses -- something that's at odds with what they mostly did in their early days -- at the most recent Berkshire Hathaway (BRKa) shareholder meeting:

"The ideal business is one that takes no capital but yet grows...if you have a business that grows, and gives you a lot of money every year, and...it [capital] isn't required in its growth, you get a double-barrel effect: from the earnings growth that occurs internally without the use of capital, and then you get the capital it produces to go and buy other businesses.

And See's Candy was a good example of that."

He later added:

"Increasing capital acts as an anchor on returns in many ways."

I'd place the emphasis on "in many ways". When a business needs to continuously absorb lots of capital the number of options available to management get reduced. These fewer options can be especially devastating during a tough business transition (whether brought on by micro or macro factors).

Over shorter time horizons -- and,in my book, a few years or less qualifies as a shorter time horizon when it comes to equity investment -- the impact on returns may not be all that obvious. Full business cycle core economics become masked. (Especially during periods of exceptional prosperity whether industry-specific or more general.) It's over longer time frames, when the impact on compounding becomes the dominant influence on total returns (instead of trading market price action), that the "anchor" becomes increasingly plain as day. This doesn't mean there aren't good capital-intensive businesses; this does mean the risk-reward profile is necessarily unique and unwise to ignore.

Buffett also mentions that Berkshire has a few businesses that earn 100 percent on capital (and this was covered to an extent in the Berkshire annual report) while their energy business produces more like 11-12 percent per year.

"And that's a very decent return, but it's a different sort of animal than the business with very low capital-intensity."  

The problem isn't only that there aren't many high return on capital businesses available; it's whether the price is right and that they're large enough to matter considering Berkshire's scale.

It's also worth remembering that it's not just about judging if a business can produce high returns on capital now. What matters most is if that business will continue doing so for a very long time -- often far from easy to judge with enough warranted confidence.

Charlie Munger followed with this...

"...when our circumstances changed, we changed our minds. In the early days quite a few times, we bought a business that was soon producing 100 percent per annum on what we paid for it and didn't require much reinvestment. If we'd been able to continue doing that, we would have loved to do it. But when we couldn't we went to Plan B. And Plan B's working pretty well and in many ways, I've gotten so where I sort of prefer it."

I'm always a bit surprised just how often I'll see an analysis or opinion on a business that places little emphasis on the importance of this "double-barrel effect".

Making an investment without giving due consideration to returns on capital --along with how competitive dynamics and technology might reduce the advantages a business possesses in a way that drastically alters future returns on capital -- is, to me, just a misjudged investment in the making. I'd have no idea how to approach risking capital in such a way.

Return on capital is all-important yet, for some reason, other factors seem to get a great deal more attention instead by some market participants. All the energy that goes into how quarterly earnings and/or some new product might impact the near-term price action of a stock -- or, alternatively, how macro factors might influence the market as a whole -- comes to mind. This is, to me, attempting to consistently guess correctly what is nearly unguessable instead of focusing that energy more productively elsewhere.

In fact, just how infrequently returns on capital comes up when someone is making a case in favor of (or against) a particular equity investment is, to me, rather revealing.

A passing mention (or no mention at all) too often is the norm whether that case is being made in writing or otherwise.*

Now, return on capital certainly isn't the only thing that matters.

Equity investing will never be that straightforward.

It just needs to be given a proper weighting.

Every business and the industry will have many unique things to consider much of which will not be quantifiable.

Well, at the very least not in a precise manner.

There's much to think about with any investment and returns on capital is just one of many important considerations. That's why trying to understand every investment opportunity is usually a recipe for understanding nothing at all with sufficient depth.

It's inevitable that a potentially attractive investment opportunity will show up on someone's radar yet should be "missed" because it just happens to be outside that investor's comfort zone.

What to avoid is necessarily unique for each investor. Knowing what one doesn't know then buying only what's understandable -- at a plain discount, of course -- generally requires the right temperament, independent thinking, discipline, and an awareness of limits over pure genius.

Here's Buffett at the 2009 Berkshire meeting:

"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's most important is inner peace; you have to be able to think for yourself. It's not a complicated game."

Those who do choose to extend beyond their comfort zone might find that justified conviction won't be there when it's needed most.


Long position in BRKb established at much lower than recent prices

Related posts:
High Returns on Capital vs High Returns on Incremental Capital
Not Picking Stocks By The Numbers
Buffett: Cigar Butts & Wonderful Businesses
Buffett: Severe Change, Exceptional Returns Don't Mix
Buffett: 57% Return on Equity Capital
Inexpensive Stock?
Circle of Competence
Inactive Investing

* I do not mean to paint with too broad a brush here. Obviously many capable investors give returns on capital the consideration it deserves.
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