The Exceptional Value Of Rare Reinvestment Economics

It's both bigger than you might think and more rare.

“The ideal business has a high return on capital, high returns on incremental capital, and can reinvest a lot of capital at that rate.” Thus spoke Warren Buffett. The value of that kind of business? Bigger than you might think. What’s the problem? They are very rare.

The typical business is not very good. It earns close to its cost of capital. The typical good business has high returns on capital, but can’t reinvest capital back into the business at anything close to that rate.

See’s Candies is a good example of that kind of business. It spits out a lot of cash, but there is no better use for that cash than sending it back to the owners.

It’s a very rare business that has all three attributes - good current returns, good incremental returns, and the ability to reinvest a large amount of capital. Let’s start with what such a business might be worth.

Using the framework of a 10% discount rate for equity Free Cash Flow, the average business is worth around 15x EPS. That business might grow profits inline with the rate of growth of GDP, produce 75% of its earnings in Free Cash Flow, and do so for 7-8 years before slowing down further.

A good business might produce all of its earnings in the form of Free Cash Flow, grow slightly above GDP, and do so for a decade before slowing down to maturity. Such a business would be worth around 20x EPS.

Starting from the baseline of a good business, let’s examine how that value would change as we make it even better.

First, let’s keep everything the same but assume that instead of 10 years the business grows at moderately above-average rates for 30 years. That takes its value from 20x to almost 30x EPS. Yet, most of Wall Street wouldn’t be too excited by this business because investors overly focus on the rate of growth and don’t focus enough on the duration of that growth.

Next, let’s assume that instead of being forced to return its Free Cash Flow back to its owners, the above business could reinvest all of that cash flow. Let’s not worry about how, but for the sake of our exercise just assume that the incremental returns are achieved.

At a 12% return on incremental capital, this business would be worth 38x EPS. Not too bad.

What about at a 15% incremental return? The value spikes to 58x.

18%? We are now at 89x.

Finally, 20%? This company would be worth a whopping 119x EPS. I am not going to go higher than this, by now you hopefully get the picture.

Oh, and one more thing. If we take this business that’s worth 119x EPS and change just one parameter - the duration of abnormal growth and reinvestment from 30 years down to a still lengthy 10, the value goes down. A lot.

How much? It drops to 38x EPS.

So what is the one thing that needs to be in place in order to have just a chance at these kinds of nose-bleed values? Management that is very good at both running the business and at capital allocation.

That’s why if you read Phil Fisher’s Common Stocks and Uncommon Profits (and you should), many of his “15 points” can be boiled down to just one word: management! And not just one person. You need something that’s sustainable for decades to achieve value creation of this magnitude.

So if this is all so wonderful, why not just look for these kinds of businesses and hold them for decades? Well, that’s a perfectly viable investment approach that many follow, and which has grown in popularity over the last decade.

The challenges? Many. Here are but a few:

1. These businesses are so rare, that you are going to have a lot of false positives. Many such “elephant-hunters” completely disagree about which businesses are the real thing, and they can’t all be right.

   You are also getting a heavy dose of selection bias from those bragging about their successes, as the people who thought that K-Mart was going to be WalMart aren’t eager to remind the public about their predictions.

2. Such businesses rarely come cheap, and certainly don’t stay cheap for long. The point in holding on to them even when they aren’t statistically cheap is that the duration of their growth and their reinvestment economics make them worth even more. Which means that when you are wrong, and the business that you bought or held at 40x+ EPS turns out to be merely a good business, you lose over half your money.

3. You have to be right about not just the next 5-10 years, but about years 10-30. That’s very, very hard.

4. The feedback loop, already long in investing, is particularly long. If you hold a business for 5 years and it does everything you thought it would, does that mean that you are right and it can do that for another 25 years? Not necessarily.

5. You can’t possibly think that you found 20+ such businesses. Well, you could, but… Let’s say you are nearly superhuman and think you found 10. For argument’s sake, let’s say that you have an equal-weighted portfolio with each one at 10% in the beginning. After a number of years, you are reasonably likely to end up with with a portfolio where 1 or 2 positions are over 50% of your capital.

   The worst part is that with this strategy you absolutely cannot rebalance by selling the winners to buy the losers. So you have to keep going forward with a very unbalanced portfolio. If you are right, then you look like a hero. And you are. But what if you are wrong on the 1-2 positions, likely at lofty valuations, that make up most of your capital?

Do these challenges mean that you shouldn’t try? That’s for you to decide. My point is this: the reward from looking for companies with exceptional reinvestment economics can be phenomenal. You are also much more likely than you might think to be overconfident and make a costly mistake.

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About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.