Thinking About Return on Capital

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Return on capital. Its a simple thing. It’s defined as the amount of money the business earns on the capital that has been invested in the business. And its also one of the attributes the world’s most successful investors are after when they’re looking for quality companies.

There are other attributes that make up a great company, too. And every investor places a different level of importance on the characteristics they feel are important; strong management, consolidated industry, high barriers to entry, attractive product, good culture, solid balance sheet, low obsolescence risk, etc. But among all these traits, one of the most common characteristics they seek is a high return on capital.

“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time, and where we think the management will treat us right.” Warren Buffett

The higher the return on capital, generally speaking, the better the business. It’s even better when such businesses can re-invest more capital at attractive rates of return. Not many businesses can do this.

“If you earn high enough returns on equity and you can keep employing more of that equity at the same rate — that’s also difficult to do — you know, the world compounds very fast.” Warren Buffett

“If you’re going to own a company for a long time, the earnings it generates today will be a small component of the eventual return.  Much more important will be how those earnings can be reinvested over time to build value.  When companies with positive compounding characteristics become available at really attractive prices, we’ll hope to take advantage.” Chris Davis

“It is not enough for companies to earn a high un-levered rate of return. Our definition of growth is that they must also be able to reinvest at least a portion of their excess cash flow back into the business to grow while generating a high return on the cash thus reinvested. Over time, this should compound shareholders’ wealth by generating more than a pound of stock market value for each pound reinvested.” Terry Smith

Such business are often referred to as ‘compounding machines.

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” Warren Buffett

"A compounder is a competitively advantaged business that earns superior returns on invested capital. As cash earnings are reinvested back into the business, the value of the business grows year after year compounding our investment.” Christopher Begg

While stock prices often swing around erratically in the short term, over the long term, a company’s share price will reflect the business’ earnings. Over the long term, all you can get out of a business are the returns it produces.

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“Bear in mind--this is a critical fact often ignored - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett

“Occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them.”  Howard Marks

“The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.” Warren Buffett

And it’s the business’ return on capital and the re-investment rate that drive future earnings, making it the key driver of a stock’s long term performance.

“A stock return will eventually echo the increase in the per share intrinsic value of the underlying company (usually linked to the return on equity).” Francois Rochon

“Over the long run, it is a company’s return on capital, not changes in quarterly earnings, which primarily determines the direction of its share price. The return on capital of any company is largely subject to the state of competition within its industry.” Marathon Asset Management

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” Charlie Munger

“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.Warren Buffett

It’s the reason Buffett and Munger steer well clear of businesses with low returns on capital.

“We like to think when we buy a stock we’re going to own it for a very long time, and therefore we have to stay away from businesses that have low returns on equity.” Warren Buffett

"If you have a business that’s earning 5 or 6 percent on equity and you hold it for a long time, you are not going to do well in investing. Even if you buy it cheap to start with." Warren Buffett

It’s also the reason Buffett and Munger et al think it’s worth paying more for businesses with high returns on capital. The high returns on capital combined with a high re-investment rate compound to drive extraordinary earnings and share price gains over time.

"Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions. But you never know 100 percent for sure. And so it isn’t as precise as you might think. Generally speaking, if you get a chance to buy a wonderful business — and by that, I would mean one that has economic characteristics that lead you to believe, with a high degree of certainty, that they will be earning unusual returns on capital over timeunusually high — and, better yet, if they get the chance to employ more capital at — again, at high rates of return — that’s the best of all businesses. And you probably should stretch a little." Warren Buffett

“Faced with the choice between investing in two companies with the same earnings growth, we are prepared to pay materially more (in P/E terms) for the business with high returns on equity and superior cash flow generation.” Marathon Asset Management

“If you invest for the long term in companies which can deliver high returns on capital, and which invest at least a significant portion of the cash flows they generate to earn similarly high returns, over time that has far more impact on the performance of the shares than the price you pay for them. Yet I have been asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not.” Terry Smith

As high returns on capital attract competition, it’s important to get comfortable that the returns are sustainable.

“For most companies, high ROE’s and dividend growth rates will quickly be competed away.James Bullock

“The problem with high ROE’s in capital intensive businesses is that it is hard to sustain the ROE’s. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROE’s. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.” David Einhorn

“Note that we are not just looking for a high rate of return. We are seeking a sustainably high rate of return.Terry Smith

A long history of high returns on capital is a sensible starting place to look for potential investments.

“We think a long history of high returns is on average a strong indication of an exceptional, durable business model - a factor to which we don’t think other investors give a high enough weighting.” James Bullock

Ordinarily such businesses are protected by a ‘moat.

“The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles’, companies whose moats proved illusory and were soon crossed.” Warren Buffett

“A truly great business must have an enduring 'moat' that protects excellent returns on invested capital.Warren Buffett

“Few businesses possess an ‘economic moat’ formed by enduring competitive advantages. Our experience reinforces the fact that it is these moats which enable the businesses to earn higher returns on capital than average" Chuck Akre

“There is a reasonably sound piece of economic theory called mean reversion which suggests that companies which generate high returns should attract competition, which will eventually reduce their returns to the average, or worse. The very small group of companies that manage to avoid this economic law of gravity have some kind of defence which enables them to fend off the competition. This is the oft quoted concept of the “moat” popularised by Mr Buffett.” Terry Smith

"Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits." Joel Greenblatt

Identifying businesses with high sustainable returns on capital and sticking with them is a sure fire way to investment success. It’s a reason, once identified, why many of the Investment Masters are reluctant to sell great companies. Regardless of what their share prices do in the short term, the intrinsic value of the business grows. Time is on your side.

“Time is the enemy of the poor business, and it’s the friend of the great business. I mean if you have a business that’s earning 20 or 25 percent on equity, and it does that for a long time, time is your friend.” Warren Buffett

“A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ. You may think you should invest in these poor companies as they are going to improve because the management will change, or they will be taken over, or their results will pick up with the economic or business cycle. But each day you wait for such events, these companies destroy a little bit more value. Good companies do the opposite. With a good company, time is on your side.Terry Smith

Little wonder many of the Investment Masters focus on buying such businesses.

“Our  ideal investment  couples  high  returns  on  capital  with  shareholder-oriented  management, where  there  is  significant  opportunity  to  re-invest  excess  cash  flow.  We  buy these  companies  when  they  appear  to  us  to  be  undervalued.” Chuck Akre

“Very simply, we are trying to find businesses that exhibit three characteristics: predictable long-term growth, high returns on invested capital and well established, sustainable barriers to competition.” Brian Vollmer

“We also require companies to have extremely high returns on capital, which we define as 20% or more sustainably.” Daniel Davidowitz

“It’s not P/E’s that matter, or profit margins on sales, but how much a business earns on the capital invested in it.” Christopher Bloomstran

Return on capital is probably the single biggest measure that I feel one has to look at. Valuations comes a distant second or third.” Rajiv Jain

As good as return on capital is as a measure of a superior business, it must be considered in the context of sustainability. Return on capital is a historic measure and so you must form a view as to whether the business is likely to be able to continue to earn those same attractive returns. This requires thinking qualitatively about the business and it’s competitive position; how is it performing today and how likely is it that it will continue to perform in the future? They’re both necessary questions.

Remember, the first rule of investing is ‘preserve capital’ which means ‘Return of Capital’. Buying businesses with highReturns on Capital’ at fair prices are what have made the Investment Masters successful. How do your businesses look by comparison?







Further Reading:
Investment Master Class Tutorial: Capital Allocation
Berkshire Hathaway 1987 Letter

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