Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
- Charlie Munger
(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)
A reader and I shared a recent exchange about the quote above. I thought it was worth sharing some of the thoughts on the blog. Here you go...
It's a Charlie Munger quote, and it's among the most important constructs for any long-term investor to understand. It goes to the heart of the return on invested capital (ROIC) portion of the economic model of a business. (See 3(d) of, "Does the economic model work?" from theMad Men MBA 4-Part Framework for Really Understanding Companies.)
Consider this...a company has $1M of invested capital (equipment, buildings, accounts receivable, etc.) supporting its business. It earns $60K on that each year, meaning it sports a six percent ROIC. Tell yourself that $1M is cash in a savings account and the $60K is your interest on your principle. The concepts are the same. You can grow your overall interest earned (earnings) by putting more cash into that account (increasing its capital), but the rate of return remains the same...a lousy six percent.
For the company, the earnings can go one of three ways in the future: 1. They decline; 2. They stagnate; or 3. They grow. What happens to those earnings is important, but it's most important in the context of what happens to that base of invested capital at the same time. Let's consider number three, where the earnings grow. (That tends to be the happiest scenario.)
Say the earnings grow ten percent a year, going from $60K to $66K to $73K to $80K, etc. Ten percent growth seems pretty good, but we have to ask how much capital had to be invested in the business to generate that earnings growth. We must always look at earnings in the context of invested capital.
If the invested capital stayed steady at $1M, you're looking at a rosy scenario in which a business doesn't have to add to its capital base to grow. That means it can probably pay out those earnings to shareholders without fear of losing its competitive position in the market and continue to compound its value. It started off earning 6% ROIC, but that number grows with each passing year (6.6%, 7.3%, 8%, etc.).
You won't find a lot of business like this. The vast, vast majority must plow back capital in order to increase earnings.
How much is this business worth? That's up to the judgment of individual investors, each of whom must attempt to predict the future in terms of whether this growth rate continues. (Are the earnings protected by competitive advantage? That's number two on the Mad Men MBA framework.) My threshold for an investment is a 15 percent yield. That means with earnings of $60K, I want to pay no more than $420K ($60K x about 7). But if I'm confident those earnings will continue growing at 10 percent, I might be willing to look, say, three years into the future, take that $80K in earnings and pay 7x that number (about $560K). But only if I'm confident that ten percent earnings growth (plus little additional capital reinvestment needs) continues deep into the future.
That exercise is nothing more than an abbreviated form of discounted cash flow. Of course it's unlikely you'll find too many businesses with $1M invested in capital, earning only six percent ROIC, trading for a fraction of its capital. Someone would likely buy the whole company, liquidate it, and take the cash for a fast, hefty, and low-risk return.
But what if earnings are growing at ten percent while invested capital is growing at 15 percent? Now the economic value of the business is being destroyed with each passing year. What would you pay for a business like this? Nothing! Unless you have the power to shut it down and cash it out. As a shareholder, you'll never get the benefit of those earnings because the business has to plow all of it back into property, equipment, accounts receivable, etc.
Munger's quote is really highlighting the famous dictum from Ben Graham's, "in the short run the market is a voting machine, but in the long run it is a weighing machine." In the short run, investors will have different opinions of the prospect for this business. The different views can lead to wildly different prices each is willing to pay, and that can lead to a lot of volatility in the stock price.
But over the long run, the economic viability of a business (its ability to compound earnings at a rate AT LEAST equal to its need to reinvest capital) will define its price. That's the weighing machine. If it returns six percent ROIC, even if you buy it at a cheap price, you won't get much better than six percent returns over extended periods of time. If it returns 20 percent (and you think it might be able to keep that up for a while), you can buy it at almost any price and you'll do fine. 20 percent is a powerful rate for compounding any number if you give it enough years to do its compounding work!
To get a mathematical proof, create an spreadsheet. Start with $1M on the row A. This is invested capital. To its right, multiply it by whatever ROIC you expect the company to earn. Say 1.1 (10 percent) and push that out 19 more rows compounding at the same rate each year.
On row B, start with $60K for earnings. To its right assign whatever multiple you want for its growth, and push that out 20 years.
On row C, divide B by A and show it as a percentage. This is your ROIC.
Now, if you select variables in which the growth of the invested capital outpaces the growth of the earnings, you'll see the ROIC creep closer and closer to zero the more years you extend the simulation. The company is eating itself. It has no economic value.
If you select variables in which the growth of earnings outpaces invested capital, you'll see those ROIC and earnings grow the further you push out the model. The business is creating economic value, and it's worth a lot more.
But it's far less about creating a mathematical proof, and much more about understanding the concept of return on invested capital. A proof might lead you down the path of seeking false precision; searching for that perfect screen that unearths all the best ROIC companies. I think of it more as a way of looking at the world of investment opportunities while thinking in terms of compounded earnings. The more a business can grow its earnings without reinvesting them (as capital) back into itself, the better its ROIC...the more it pays out to its investors (dividends or share repurchases) while continuing to compound.