The Holy Grail Of Long-Term Investing
A core test of success for a business is whether every dollar it invests generates a market value of more than that amount for the shareholders.
Warren Buffett calls this the one-dollar test. He explained:
“Unrestricted earnings should be retained only when there is a reasonable prospect—backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future—that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.
This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”
For an increase in earnings to be evaluated properly, it always should be compared with the incremental capital investment required to produce it.
When Buffett talks about a dollar of retained capital creating a dollar of market value (he prefers to apply this test on a five-year rolling basis), he talks about a dollar of intrinsic value. He implies that the stock market will be a fairly accurate judge of intrinsic value over time.
A simple way to do a quick one-dollar test is to compare the change in a company’s beginning and ending market value over some time to the change in its beginning and ending retained earnings values.
Buffett said the market, over time, will reward those companies that create high returns on the dollars they keep (by giving them a higher valuation multiple) and will punish those whose retained dollars fail to earn their keep (by giving them a lower valuation multiple).
According to Charlie Munger, “Over the long term, it is hard for a stock to earn a much better return than the business which underlies it earns.
For example, if the business earns 6 percent on capital over 40 years and holds it for that 40 years, you’re not going to make much different than a 6 percent return even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a good result.”
The math behind Munger’s assertion is easy to follow. An 18 percent return on invested capital (ROIC) over a multi decade period will dominate a 6 percent ROIC in shareholder returns.
One of the biggest challenges in investing is determining the competitive advantage of a business and, more importantly, the durability and longevity of that advantage.
Competitive advantage is defined as a company’s ability to generate “excess returns,” that is, ROIC less cost of capital. A sustainable competitive advantage is defined as a company’s ability to generate excess returns over an extended period, which requires barriers to entry to prevent competitors from entering the market and eroding the excess returns. This, in turn, enables excess returns on invested capital for extended periods (also known as the competitive advantage period, CAP).
Growing companies with higher returns and more extended CAPs are more valuable in terms of net present value. This is because the value of a company's CAP is the sum of the estimated cash flows generated solely by these excess returns, discounted for the time value of money and the uncertainty of receiving those cash flows.
Buffett emphasized "moats" as the central pillar of his investing strategy.
"The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
Great businesses have an ever-increasing stream of earnings and almost no major capital requirements. As a result, they generate extremely high returns on incremental invested capital. All genuinely great businesses are constantly drowning in cash. They have infinitely high returns on capital because they require little tangible money to grow and are driven by intangible assets such as a company's brand name with "share of mind," intellectual property, or proprietary technology. Great companies typically have negative working capital, a low fixed asset intensity, and real pricing power.
Customers who pay cash upfront for goods or services delivered later have negative working capital. Customers are essentially financing the company's growth through prepayments, a powerful catalyst for a growing company. The best part is that the interest rate on this financing is 0%, which is challenging to beat.
Negative working capital is common in subscription-based business models where customers pay in advance for recurring services or access. Because revenue is recognized when the service is rendered, these companies typically have operating cash flow that exceeds net income after cash is received.
The franchisor business model involves the franchisor collecting royalties from franchisees in exchange for using the brand name, business plan, and other proprietary assets. As franchisees contribute capital to the construction of new locations, the overall system expands, allowing the franchisor to increase revenue and earnings without deploying additional capital. This business model is great if it can be scaled up because it is capital-light and generates a lot of free cash flow by simply leveraging the franchisor's brand-name equity.
This is why, Buffett said, "The best business is a royalty on the growth of others that requires little capital itself." Firms with low fixed asset intensity outsource their core manufacturing activities while focusing on design, marketing, and branding.
If the company offers a differentiated product or service, has high switching costs, or is critical to customers (while accounting for a negligible portion of the overall cost), it may consistently raise prices above inflation. Because the flow-through margins on price increases are typically relatively high, this method is the simplest way to grow earnings without additional capital.
Companies like Bloomberg and See's Candies have a long history of raising prices at or above inflationary rates, and Buffett considers this to be one of the most important factors to consider when analyzing a business: "The single most important decision in evaluating a business is pricing power."
“If you can raise prices without losing business to a competitor, you have a great company."
Great companies are uncommon, scarce, and thus valuable. When the market predicts the longevity of growth with a high degree of certainty, they are usually given rich valuation multiples. Indeed, in today's world of rapid change, the longevity of development is becoming increasingly scarce. In the 1960s, the average time a company was in the S&P 500 was about sixty years. Today's average is only ten years. Fewer than 12% of the Fortune 500 companies in 1955 were still on the list in 2017, and 88% of the companies in 1955 had either gone bankrupt or merged with (or were acquired by) another firm. They are no longer among the top Fortune 500 corporations (as ranked by total revenues) if they still exist.
This is the epitome of Joseph Schumpeter's "creative destruction."
The market places a high value on certainty. Stocks that promise years of predictable earnings growth tend to overvalue for a long time until they can no longer grow earnings steadily. The market values predictability of long-term growth more than the total rate of near-term growth, so a stock that promises to increase earnings at 50% for the next couple of years with no clarity after that receives a lower valuation multiple than a stock that has slower but highly predictable growth over a much more extended period.
Consistent growth raises valuation while constant disruption lowers valuation.
The market always gives longevity of growth more weight than the absolute growth rate, so stocks with 12 to 15 percent predictable earnings growth for the next ten to fifteen years often have current year price-to-earnings (P/E) multiples of 40 to 50. Most new investors are perplexed by this phenomenon, but they learn to appreciate the market's finer nuances and respect its wisdom with time. Because investors in such stocks are generally willing to sit out periods of high valuation until earnings catch up, the expensive, high-quality secular growth stocks tend to remain at elevated valuations for extended periods. Markets reward companies that can promise years of consistent earnings growth at a disproportionately high rate.
The scarcity premium principle applies to the number of high-growth stocks available in a given sector as well as the overall market.
For example, suppose only a few companies in the market can achieve such high growth rates. In that case, a company with a perceived sustainable growth rate of 30% to 35% often ends up with a P/E of 40 to 50 (or an even higher valuation that generally keeps expanding throughout the entire duration of the bull run, as long as the high growth expectations are intact). In contrast, a company growing at 20% may not get more than 15% to 20% P/E if many 20% growers are available. (This is why focusing solely on the P/E-to-growth ratio, also known as the PEG ratio, can result in suboptimal return outcomes.)
When growth is scarce, market breadth narrows, and demand-supply dynamics take over. Investors want the assurance that change will occur (whereas they are ready to take a leap of faith). During such times of uncertainty, the market's focus becomes exceptionally narrow, and valuations of a select few high-quality growth stocks continue to expand until their growth rate remains above-average in comparison to the majority of the market's stocks. (Most investors remain in denial during this stage, as these expensive stocks continue to rise in price.) When growth finally slows, the valuation de-rating begins.
The actual threat to a bull market stock is not excessive valuation but a sharp correction in the investor community's growth expectations. Valuations remain high until the company achieves above-average growth rates, at which point they become excessive. Markets adore companies that can persuade them that they can consistently provide above-average rates of change over more extended periods of year's high return, and they reward them with rich valuations.
Investors who have a bias against high P/E stocks miss out on some of the most outstanding stock market winners of all time. Over ten years or more, a high P/E company that grows earnings per share at a much faster rate will eventually outperform a lower P/E company that grows at a slower pace. This is true even if there is some valuation depreciation in the interim period for the former. So, when choosing between a 15% grower at 15 P/E and a 30% grower at 30 P/E, investors always go with the latter, especially when longevity is highly likely.
As investors, we are constantly looking for "emerging moats" to capitalize on the company's initial high growth years and subsequent valuation rerating. A lower-margin and higher-capital-intensive business-to-business (B2B) company transitioning into a higher-margin business-to-consumer (B2C) company with better terms of trade is an example. So even if we miss the initial high growth phase but identify these emerging moat businesses during their intermediate stages, we can create a lot of wealth over time.
To grow and produce reasonable returns on incremental invested capital, good businesses require significant reinvestment of earnings. As a result, many companies fall into the put-up-to-earn-more category.
Gruesome businesses earn less than their cost of capital while still striving for rapid growth, even if that growth necessitates large sums of additional money and destroys value. These companies are typically capital-intensive and subject to rapid technological obsolescence.
They never make any real economic profits because they are subject to the "Red Queen effect," which means that they either keep investing more and more capital in keeping up with competition and maintain their starting position or stop investing in new technology obliterated. (Debt, intense competition, and high capital intensity combine to form a lethal cocktail.)
"The worst business of all is the one that grows a lot, where you're forced to grow just to stay in the game at all, and where you're reinvesting capital at a meager rate of return," Warren Buffett. Sometimes people are involved in those businesses without even realizing it."
As a result, the management of these companies frequently mindlessly mimics their competitors after succumbing to what Buffett refers to as the "institutional imperative." They are oblivious that they are constantly attempting to run up a down escalator whose pace has accelerated to the point where upward progress has ceased. As a result, they are caught off guard by the industry's rapid growth rate and fail to heed Benjamin Graham's caution: "Obvious prospects for physical growth in a business do not translate into obvious profits for investors."
Buffett learned this vital lesson from his teacher. "The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage." So, be wary the next time an analyst or so-called market expert touts an industry's rapid growth rate as justification for investing in stocks within that industry. When all other factors are equal, a higher ROIC is always preferable. Unfortunately, the same cannot be said for expansion. Individual stocks and their economic characteristics are central to investing.
If you want to participate in the high growth rate of an industry with low profitability, do so indirectly through an ancillary industry with better economics and lower competition (the best-case scenario would be if it's a monopoly business and the sole supplier to all of the primary industry's players).
For instance, the organized luggage industry in India (characterized by moderate competition) could be used as a proxy to profit from airline traffic growth (characterized by hyper-competition).
Buffett summarises the discussion with an excellent analogy:
"To summarise, think of three types of savings accounts.”
The great one pays a highly high-interest rate that will rise as the year progresses.
The good one offers a competitive interest rate, which is also earned on additional deposits.
Finally, the dreadful account pays a pitiful interest rate and requires you to keep adding money at those pitiful returns.
We prefer businesses that drown in cash.
An example of a different business is construction equipment. “You work hard all year, and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.” —Charlie Munger.
The author adores that Munger mentions, which sends him a check from its owner's earnings every year. However, ideally, he looks for a company that will forego a review because it has appealing internal reinvestment opportunities. In other words, the author prefers a company that consistently generates high returns on invested capital and reinvests a significant portion of its earnings at similarly high returns. This is the long-term value investor's holy grail.
True internal compounding power produces two factors:
Return on incremental invested capital and reinvestment rate. This compounding power creates enormous value over time.
Reinvested profit and compound interest are the two main concepts. Typically, "compounding machines" have a niche positioning or a long-term competitive advantage that allows them to achieve high returns on capital over time. The key to investing in these reinvestment moats is the conviction that the growth runway ahead is long and that the competitive advantages that generate those high returns will last or improve over time. When the author wants high-ROIC companies, he looks for a return on incremental invested capital (ROIC), a company’s return on its total investments over time.
Its returns on total invested capital determine the growth of an organization’s intrinsic value. ROI determines whether the susceptible change is good or bad. High growth is beneficial and adds value to companies with a large spread between ROIC and the cost of capital. All else being equal, faster growth translates directly into a higher P/E multiple for such companies. The value of high-ROIC companies is sensitive to changes in perceived growth rates.
In most cases, investors mix up incremental ROIC with ROCE (return on capital employed) or ROIC. Value creation is driven by ROI (return on investment less cost of capital). Even if legacy moat businesses with established franchises and few or no growth opportunities have a high return on invested capital, it is unlikely that you will achieve exceptional returns if you buy their stock today and hold it for ten years.
The company's high ROIC, in this case, reflects returns on initial invested capital rather than the incremental invested capital. In other words, a 20% reported ROIC today is not worth as much to an investor if there aren't anymore 20% ROIC opportunities to reinvest the profits. Mature legacy moat businesses with high dividend yields may preserve capital, but they are not particularly good at compounding wealth.
The author prefers businesses that increase their intrinsic value over time. This type of growth provides a margin of safety in the valuation and the gap between price and intrinsic value, which widens over time as the business value grows.
For example, if two businesses (Company A and Company B) have the same current ROIC of 20%, Company A can invest twice as much as Company B at that 20% rate of return. As a result, company A will create much more value for its owners over time than Company B. Both businesses will produce a 20% ROIC, but one is superior to the other. As a result, company A can reinvest a more significant portion of its earnings, resulting in more intrinsic value over time. As a result, the longer you own Company A, the greater the disparity between Company A's and Company B's earnings.
This is a crucial point that cannot be overstated. Although valuation is more critical in the short term, quality and growth are more important in the long term (seven to ten years and longer). The longer you own a stock, the more important the company's quality becomes. Your long-term returns will almost always approximate the internal compounding results of the company over time. It is far more important to invest in the right business than worrying about paying 10 or 20 or even 30 percent of current-year earnings.
Many mediocre companies are available for less than ten earnings, resulting in mediocre long-term results for long-term owners.
The intrinsic value of the quality business increases over time, thus increasing the margin of safety in the event of a stagnant stock price. This is a pleasant situation because it creates antifragility for an investor. In contrast, if a business is shrinking its intrinsic value, time is your enemy. Therefore, you must sell it as soon as possible because the longer you hold it, the less it is worth.
You may wonder how to predict whether the attractive returns of the past will continue in the future. Buffett shared his insights on long-lasting businesses "The Fortune champions may surprise you in two ways."
First, in comparison to their interest-paying capacity, most use very little leverage. Outstanding businesses rarely need to borrow.
Second, except for one "high-tech" company and several others that manufacture ethical drugs, the companies are in industries that appear to be rather mundane on the whole.
Most non-sexy products or services were sold the same way ten years ago (in more significant quantities now, or at higher prices, or both). The track record of these 25 companies demonstrates that maximizing an already strong business franchise or focusing on a single winning business theme is what typically produces exceptional economics."
In terms of percentages, the "statistically cheap" securities category is likely to have fewer errors—that is, fewer permanent capital losses—than the "high-quality compounder" category. This does not imply that one will perform better than the other, as a higher winning percentage does not always mean higher returns. However, focusing on high-quality businesses is more beneficial if you reduce "unforced errors" or lose investments. When you invest in high-quality compounders, your life as an investor becomes so much easier.
Buffett advises: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually sure to be materially higher five, ten, and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock.
Consider that ₹20,000 invested in great companies (Hawkins, ITC, Titan, and HDFC Bank) increased nearly fivefold to ₹100,000 in five years. In contrast, the same money invested in gruesome companies (Reliance Communications, Reliance Capital, DLF, HDIL, and GMR Infra) was destroyed and would have been worth only ₹3,000. This led the author to one of the most important discoveries of the author’s investing career: great businesses created a lot of wealth even when measured from the peak of the previous bull market to the end of the subsequent bear market.
To achieve significant wealth creation, an investor-only needed to be disciplined and stay the course during turbulent times in the stock market. In the short term, liquidity and sentiment drive the market index, whereas individual company earnings drive stock prices over time. As a result, great businesses generate enormous wealth over long holding periods across market cycles, even in the face of negative macroeconomic headlines about high inflation, rising interest rates, geopolitical tensions, weak macroeconomic data points, and political uncertainty. But, on the other hand, whether the news is positive or negative, gruesome businesses eventually destroy wealth.