Free eBook
Click on image to view and download.
Free Updates via RSS
The Ability to Reinvest Capital: The Mark of Investments that Generate Wealth
Markel Corporation, which has a long-term record of compounding capital at a high rate of return under the investment leadership of Tom Gayner and Steve Markel, has a four part equity investment philosophy. They seek, “To invest: 1) in common equity of profitable businesses with good returns on capital, 2) with honest and talented management teams, 3) with reinvestment opportunities and capital discipline, 4) at fair prices.”
I want to focus today on part 3 of Markel’s philosophy. Businesses that can reinvest their capital at high rates of return can generate tremendous wealth over time. They’re the mathematical equivalent of finding a savings account that pays 15-20% interest where you can reinvest your earnings at that same high rate of return for the next ten to twenty years.
Many otherwise very good businesses that throw off a lot of cash – See’s Candies, Google, Microsoft, etc. – reach a point where they are not able to find places to allocate their capital at a high rate of return. For See’s, it was the inability to expand the concept much beyond its core base in California, where it enjoys unusually strong share of mind built up over decades of superior execution. For businesses like Google and Microsoft, their core businesses throw off far more cash than is needed in those business units, and their managements have yet to find an answer for their growing cash balances.
This is less of a problem if you control the business, because you can take the excess cash and intelligently redeploy it. This is precisely what Buffett did with the excess earnings of See’s. With partial ownership of public companies, you are at the mercy of management’s capital allocation decisions. This is another reason to carefully evaluate the management team of a potential investment.
One of the best examples of a business with reinvestment opportunities I’ve come across is Buffett’s example of Thompson Newspapers from a speech Buffett gave at the University of Notre Dame in 1991.
Thomson Newspapers, which most of you have probably never heard of, actually owns about 5% of the newspapers in the United States. But they’re all small ones. And, as I said, it has no MBAs, no stock options – still doesn’t – and it made its owner, Lord Thompson. He wasn’t Lord Thompson when he started – he started with 1,500 bucks in North Bay, Ontario buying a little radio station but, when he got to be one of the five richest men, he became Lord Thompson. I met him one time in England as a matter of fact, in 1972, and went up to see him. He’d never heard of me, but he was a very important guy. (I’d heard of him!)
I said, “Lord Thompson, you own the newspaper in Council Bluffs, Iowa. Council Bluffs is right across the river from Omaha, where I live, four or five miles from my house. I said, “Lord Thompson, You own the Council Bluffs [Daily Nonpareil?]. I don’t suppose you’d ever think of selling it?” He said “I wouldn’t think of it.”
Lord Thompson, once he bought the paper in Council Bluffs, never put another dime in. They just mailed money every year. And as they got more money, he bought more newspapers. And, in fact, he said it was going to say on his tombstone that he bought newspapers in order to make more money in order to buy more newspapers [and so on].
So, where do you find businesses like that? The answer lies in 1) knowing what you’re looking for, 2) having a great search strategy, and 3) working that strategy hard on a consistent basis.
One type of business that has ample reinvestment options at high rates of return is an insurance company run by a great capital allocator, such as Berkshire Hathaway (Warren Buffett), Fairfax Financial (Prem Watsa), Markel (Tom Gayner), or Greenlight Capital Re (David Einhorn). These businesses have both a go-anywhere investment philosophy coupled with a disciplined investment process.
Very few businesses can continue to allocate capital the way these companies can. Moreover, because many CEO’s lack the skill to allocate capital outside their core business, moving beyond their circle of competency may actually destroy value.
The takeaway is to learn to identify these types of businesses and to consciously look for them as you execute your search strategy. You don’t need many of these to get rich.
2 Responses to “The Ability to Reinvest Capital: The Mark of Investments that Generate Wealth”
Comments
Read below or add a comment...
Great post. I came across a useful indicator that looks at management’s ability to reinvest capital, I found it in the book “It’s Earnings That Count” by Hewitt Heiserman. Heiseman has a metric he calls ‘Return On Greenest Dollar’, the more money a firm earns on its latest investment in enterprising capital (that is debt, stockholder’s equity, capital equivalents) the better. The ‘green’ in greenest dollar refers to last years investment in the business, rather than total capital.
To quote Heiserman, “Many erstwhile blue chips get into trouble by investing in low yielding projects in order to maintain the illusion of earnings growth. It’s much harder to fool the return on greenest dollar equation, however. Successive disappointing returns on greenest dollar will eventually pull down a firms total return on capital, which in turn will hurt enterprising profits.”
I like your post, but I feel as though you missed one way in which businesses can make money on their “invested capital”. Typically, when someone with an accounting background hears a “return on invested capital”, they would normally think immediately about investing in fixed assets. This could come from the idea of “investing cash flow” from the cash flow statement, or just the idea that as you invest money in fixed assets, those fixed assets will generate a return. I am assuming those are the types of businesses you are speaking about- those with high returns on their most recent investments in fixed assets (or perhaps their most recent purchase of another business).
There is another way a business can make money on “invested capital”. Buffett calls it “return on invested capital”, and for the first year or so, I figured he meant “return on most recent investment in fixed assets/their most recent buyout of another company”, but that is not what he means. When he talks about it (i’ve only seen him make this distinction once, in relation to See’s Candy), he means the return on working capital. Working capital is the money required to operate a business, and the more money you need to run a business, the less you have left over for yourself.
You spoke of companies that “throw off” a lot of cash- those are good examples of companies with high returns on “deployed capital” (what I call it, instead of invested capital). Buffett talked about See’s Candy, and that when he purchased it, it made him $5 MM in operating profits each year off of $8 MM in working capital. He said that as See’s grew, it ended up needing $40 MM in working capital to operate today. He said that See’s only needed to retain $32 MM as the business grew, and they sent the rest of something like $1.3 B in excess cash to Berkshire over the last 40 years.
For See’s, this $5 MM in op. profits from $8 MM in working capital leads to a 63% “return on deployed capital” (5/8). Li Lu spoke to Columbia students saying that above a 50% return on deployed capital is one thing that can be considered in a great business. It allows for a business to send profits toward paying off debt or using it to reinvest elsewhere. He is the man replacing Buffett if you haven’t heard of him yet.
This above 50% distinction is the ability for a business to turn a dollar of working capital into 50 cents each year. With enough time to allow that to compound in your favor, you will do quite well. Some businesses generate much higher returns than this (Home Depot is around 300%, Wal-Mart has negative working capital- it requires NO money to operate).
I just wanted to throw that out there- I hope I am not making myself look like a fool if this is the type of “return on invested capital” that you were talking about.
I just found your website- I look forward to checking out everything you have on here. I fixed my name- sorry about the confusion.