The best way to learn is by studying the best. Experience has value as long as it also has a foundation in knowledge. Reinventing the wheel again and again is a fool’s errand and not conducive to personal development.
Studying the best takes many forms. Working for someone at the top of their game is the best way to learn, but the opportunities to do so are limited. Formalized education communicates facts without always presenting the best in your selected field. The number one way to learn from the masters is to study them through intense research of their work. The greatest minds are available like never before. YouTube videos of their speeches and books and news articles on their practices give us massive quantities of material to learn from.
Today we will focus on a simple story shared by Charlie Munger, Warren Buffett’s friend and right-hand man at Berkshire Hathaway.
Tell Me a Story
Munger gave a talk to the USC Business School in 1994 where he shared a story Buffett told when lecturing at business schools. Here are the exact words Munger used:
When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”
He says, “Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”
Buffett’s story is about more than investing; it’s about life. People buzz around trying to do everything and end up doing poorly in each endeavor. Investors trade stocks like baseball cards; people buy home after home believing they are moving up with each new personal residence; employees keep moving from job to job looking for more . . . ; business owners search for new clients endlessly.
Around here we encourage index fund investing. It’s a perfect way to set it and forget. That counts as one punch on the 20-slot card. I have a mad money account where I invest a small portion of my liquid net worth. The account only has a handful of stocks. By limiting how many companies I own I spend more time researching those companies and evaluating their prospects.
I also make incredibly stupid mistakes and pay the inevitable price for such mental lapses. In the late 80s and 90s I was in a partnership with my dad and brother. We bought real estate. A lot of real estate. By the time we were done we had 176 properties to consume our lives. Actually, my dad and brother were not involved so “I” had 176 properties to consume “my” life. I punched my 20-slot card 176 times!
Lack of focus hurt results. I had properties spread out over a 200 mile radius. Multiple property managers were involved. We had the money so we kept on buying. And selling.
Eventually I experienced burnout. The fun, even the desire for profit on it, was gone. The buying stopped and the selling accelerated until there were no more properties. The partnership was done. Countless hours yielded a good, but not great, return. The lust for more for more’s sake cost dearly. Lesson learned. Kind of.
What could I have done better? The money was there and so were the opportunities. Burnout could have been avoided. If I would have heard Buffett’s advice back then it would have saved me from plenty of pain.
The 20-slot rule applies to more than stock investing. Rather than buy so many single-family homes I should have bought fewer multi-unit properties. I toyed with the idea at the time. I reviewed a serious number of apartment complexes and commercial properties. The numbers were compelling. In many cases the profit potential was higher than anything I could earn with my current mix of investment properties. The reason why I decided to pass on multi-unit buildings was because it would be harder to sell such properties and would likely take longer as well since fewer buyers were in the multi-unit market.
If Munger were standing beside me he would have smacked me up behind the head. I can hear him say, “Idiot. Think like an accountant!”
Warren Buffet says you should buy a stock as if the stock market will be closed for five years. The point again is to focus on the investment and invest for the long haul. I didn’t buy fewer large value buildings because it would be harder to sell them. I acted like real estate should be day-traded. SMACK!
The missed opportunities are only talked about now. My choices when I ran LuK Enterprises cannot be changed. It’s in the history books. At least I learned my lesson. Right?
Thinking like an Accountant
This blog is about teaching people to think like an accountant. You would think an accountant with decades of experience could communicate such a message with clarity. You would also think said accountant would walk the talk. Welcome to my fantasy world.
I share my failures in business (and sometimes in life) because that is where the opportunities to learn exist. Plenty of successes brought me to this place. Bragging about the times I knocked it out of the park would waste both our times.
Sometimes a 20-slot card is too many slots and other times too few. For example: In my practice I have more than 20 clients. Most businesses require more than 20 clients to be viable and to reduce risk. One client should not determine the success of a company.
As my business has grown over the years and with this blog, I find myself saying “no” to new clients more often. My practice is small for a reason. I enjoy the work. Expanding to additional locations would not make me happier. Quite the opposite. More locations and more clients would reduce the relationships I have with my current clients. A thousand clients is too many at times already.
My 20-slot card has only one slot when it comes to marriage. Two slots would be too many for me. Even my dating card had fewer than 20-slots. I dated fewer than five women in my life. Two received more than one date and only one became my wife.
I never understood the idea of dating a large number of people to find Mr. or Mrs. Right. The answer is obvious when speaking with a potential mate before it ever gets to the first date. If the answer is obvious, why invest the time? You are not dating to see if this person is right for you; you are dating for the opportunity for a piece of ass. Be honest. You know it’s true.
There is no guarantee a mate will work out. Divorce happens for a variety of reasons. If a young lady doesn’t fit my vision of a life mate we can still talk and be friends. All the emotional baggage is eliminated before it is ever created.
Most people take whatever comes their way in interpersonal relationships. I am no fan of luck. I actively sought out Mrs. Accountant. I would come to the table with a one-slot card and was darn careful about punching that slot.
None of this guarantees success. Limiting the number of stocks you buy, researching to the nth degree an investment does not guarantee it will work as planned. But you do increase the odds by magnitudes of order it will.
Buffett has owned more than 20 stocks in his life. The 20-slot rule is not hard and fast. It is a metaphor to remind you to spend more time focusing on fewer projects.
Focusing on a narrow group of projects is the only way to maximize profits or pleasure. When I find a good company I keep adding to it. Index funds should be the bulk of more people’s investments. It’s an awesome idea so you can comfortably keep adding to the pile whenever funds are available.
In my practice I add clients selectively. Opening new offices and expanding rapidly might work as long as I accept the greater risks of growing my type of company to such proportions. When there is room I add to an already successful business model. It works and it is profitable.
Even in my marriage I keep adding to the one investment I have made. Having an affair or spreading it around is of no interest to me. There is no doubt I would NOT be happier playing the field or searching for something better.
At the risk of sounding cold, I am not looking for the absolute best stock on the exchange; I’m looking for one I can live with for a lifetime.
My marriage is the same way. I never intended to find the perfect person I would be most compatible with. Heck, she probably lives in Timbuktu. It’s not going to happen. I found someone, Mrs. Accountant, who I knew I could enjoy a lifetime with. No need to punch 8,304 slots on the dating card to come to that conclusion.
Or you can keep chopping your 20-slot card to bits in an attempt to find the ultimate investment or mate. But be warned; you will not be happy with what you get.
Here is an important interview with Warren Buffett everyone needs to listen to as we face significant tax code changes from the new administration. Warren’s views are not always mine, but his fundamental understanding of taxes and how they work requires all intelligent people to listen and learn as we grade our representatives on how well they are leading.
Over the years I have met some truly awesome people. Mrs. Accountant and I used to frequent science fiction conventions and stalk authors I enjoyed reading. You would be surprised how many were thrilled (they acted thrilled) to break bread with the missus and me. Many of my heroes have either died or are getting up in age. I miss Zig Ziglar; I have a picture of me shaking hands with him over breakfast. Tony Robbins was busy as heck but still took time to talk. Beside my office desk I have a picture of me, Mrs. Accountant, Newt Gingrich, and Mark Green. Newt was Speaker of the House at the time and he was promoting his Contract with America. For the record I vote both side of the isle; it just happens the opportunity to have my picture taken with the Speaker of the House came up so I took it. Also sat at a round table with the Speaker and five other people in Green Bay talking politics and taxes.
There are more people I would love to meet. Unless you run in a tight group you may not know many of these folks. It’s okay. You can look them up. Most are writers; writers always thrill me. I met Pete Adeney (Mr. Money Mustache) a few years back and as readers here know I am now his tax guy. The problem with meeting some people is it costs money. Either you need to attend a conference and there is little opportunity to spend any real time with the mark, ah, I mean gentleman, or people like me never have a real chance for a sit-down lunch with the victim because the victim is too famous.
I know you are licking your lips so here is my short list of people I would love to chat with over a beer or a light meal:
Warren Buffett: Warren is one of the most interesting people I can think of. He auctions off a dinner date with him once a year for charity to discuss anything you want. The winner pays over a million dollars for the opportunity. Mere mortals don’t have a chance. The closest I will ever get to Warren Buffett is a client who is board of director for a company financed by Berkshire Hathaway, Buffett’s company. I put this one first because of the 2,500 people who visited this blog in the last month one might have been Warren Buffett. (Yeah, right!)
If Buffett ever allowed me to have personal time with him over a meal I would ask him about happiness. Here is a guy who has lived a long time, made a lot of money, and still seems happier than the day is long. He found meaning in life when all the creature comforts life can offer were never in doubt for a long time. I would ask: What makes it all worthwhile? What makes you proudest?
Stephen King: Over the years I met a lot of writers, including several New York Times bestselling writers. But when you want to sit for twenty minutes with Stephen King you might not get the same reception. He sounds like a great guy to shoot the shit with. He gave up alcohol (my understanding) years ago so a bottle of Coca Cola would do just fine for our conversation. I would ask Stephen about the language and when to break the rules to communicate more accurately. I spend plenty of time writing and struggle. King knows how to push a noun up against a verb; me, not so much. Sometimes I don’t even know I am screwing up grammatically. I would ask Stephen how he knows when to look things up.
If Stephen King ever granted me an audience I would beg “pretty please” to have a tour of his home and office. I am curious how the guy that thinks up such deliciously spine-tingling stories lives. Ah, he’ll never give two shits about a country boy like me. I’m sure I’d be disappointed to learn he puts his pants on one leg at a time anyway.
President Bill Clinton: Now that Hillary leads in the polls it might be time to ask Bill what he plans on doing in the White House with all that free time (Don’t answer that!) President Clinton is an interesting man to me and it goes beyond politics. I would enjoy an afternoon on the ranch with President George W. Bush too, but they have guns down in Texas and Weesconsin boys might not be welcome.
The thing about Bill Clinton is he is sixteen years from his presidency and his wife looks to be heading for the job next round. I would ask Bill (can I call him Bill?) what his proudest accomplishment in office was and what he hopes Hillary would accomplish should she win. Outside the scandal and sex stuff, I would ask what he felt was his greatest error. After the first ten or fifteen minutes and the third beer I would hope the conversation drifted toward the simple pleasures of life like, What makes a good day? Presidents always make for a good afternoon conversation.
Now we move from the impossible to the someday-it-could-happen.
Ryan Holiday: Holiday is a writer with a long career in marketing. He is 29, but is wise well beyond his years. Reading his books you have no idea a young man is writing it; you would think a man with a full life behind him was writing the book. His career started by manipulating the media for his own gain or that of his clients. He has matured.
My questions would be simple for Holiday. He has studied and practiced stoicism from a young age. My questions would be more of a conversation on how to live life well following stoic principles. An afternoon (I would need the full afternoon) would only be the beginning. Holiday is the kind of guy I think I would like to call friend after a heart-felt afternoon of shared ideas.
J.D Roth: You would think this one is possible since Pete Adeney and J.D. are friends. Roth started the blog Get Rich Slowly and now writes for his newest blog, Money Boss. My time with J.D. would revolve around life choices. I have a difficult time letting go of work and career. I would pick his mind for ideas to live a full and meaningful life. J.D. enjoyed a very extended road trip with his family and I would love to hear more (he wrote plenty) about the trip. Not the details of where he went and what he saw, but, how did he handle life away from home for so long? I think a sit-down with J.D. would include Pete, beer, and a lot of shoot-the-shit conversation. Just the way I like it.
Leo Babauta: Leo does not know me from Adam. He writes the blog Zen Habits. I love his work because he helps me do something I have a hard time doing on my own: relaxing. I don’t think readers here understand how little sleep I get. I frequently write these posts late at night and edit them next morning. It is 10:30 P.M. as I write these words. I will go to bed, but I usually sleep on the couch so I don’t disturb Mrs. Accountant. I toss and turn a lot. I get up several times overnight; my mind never stops. Leo’s work has slowly helped me declutter my life.
An afternoon tea with Leo would hopefully help me relax. Of course I could always spend serious money to attend a conference to see him, but it would not be quality time. An afternoon chatting with Leo would probably allow me my first night of full sleep in decades. I would ask Leo how to turn it off. My mind is always racing with ideas. It would be a blessed respite for the voices to stop for just a day. Until then, I’ll keep reading his work.
Tim Ferris: Ferris is the guy who writes the 4-hour books. The 4-Hour Workweek is his most popular work. My question for Tim is simple: What the hell you do with all your free time? For Christ’s sake, when I had fifteen spare minutes one day I bought a farm to fill the wasted time. Life is easy today, no doubt. The amount of work required to satisfy “needs” takes, like Tim Ferris postulates, about 4 hours a week. After that it all goes into investments or stupid spending. Guys like me who need constant activity (constructive and productive activity) to calm the demons needs to know how guys like Ferris pull off the stunt. It sure eludes me.
Now we move to my last “must-see” person I would love to share an afternoon beer with:
You, My Readers: Anybody who suffers through my writing must be special. I love it when I get comments. Everyone sounds so awesome. I can’t meet each and every one of you. I just checked Google Analytics and it tells me 2,568 different people showed up here in the last month. That number has been growing about 50 a day lately; this thing is really starting to take off. As the numbers grow I know my chance to personally touch each and every one of you dims. The sheer volume will eliminate any chance I have of knowing you personally. I hate it with a passion. I am a people-person. I live for the stories people tell about their life. Maybe we get lucky and have a few moments to connect someday. I hope so. Most of you are only a computer screen to me.
And now this post is at an end. I miss you already.
From an early age I practiced picking out conversations from a crowd. It’s a neat little trick for a business owner to have. When you think I cannot hear you I may actually be listening in closely. Conversation in a crowded room takes skill with multiple conversations amped in volume so you can be heard over the cacophony. Picking out a select voice from across the room takes a lot of practice.
At a recent social event I put my talent to good use. The trick is to focus on only one voice. Focus is the key. I move from voice to voice, focusing on the words until I find one I find interesting. I do all this while talking with my friends. You would be amazed at what people say in a crowded room when they assume only their little group is listening. On this particular event I honed in on a man talking about people he does not trust. I found this interesting so my radar swung into action, focusing on the conversation the two men were having while maintaining an intelligent conversation with my mates. So I don’t interrupt, I never make eye contact with the people I am focusing on. The man continued, “I don’t trust people who act like they are perfect; they never smoke weed or drink or do anything wrong.” He went on a bit more before changing the subject. The new subject did not interest me, so I moved on. But by now I was mulling what the man had said.
Successful people—interesting, I might add, too—tend to push and stretch the rules further than average. Good people test the boundaries. Can you imagine Steve Jobs not pushing the boundaries? We would still be using a rotary phone hanging on the wall if he did. In Walter Isaacson’s biography of Steve Jobs he tells the story of Steve getting pulled over for going 100 mph on the freeway. As soon as Steve had the ticket he took off and accelerated back up to 100. For some reason Steve Jobs did not think the rules applied to him.
Rules are meant to be broken. That is why they make rules. When we are told, “You can’t do that!” it is not a restriction, but a challenge. Business leaders do, what is claimed, cannot be done: computers have no practical use; you can’t make a cell phone like that; people like you can’t run a hyper-profitable accounting firm and write a blog. Each of us has heard the restrictions placed on us. It is up to us if we want to listen or accept the challenge.
Like the man across the room, I don’t trust people that act holier than thou. The more innocent someone claims to be, the dirtier I know they are. Shakespeare got it right: The lady doth protest too much, methinks. At least I tell people I’m full of shit; no mystery there. I push the envelope whenever possible. How do you think I created several successful businesses and hired numerous people? I had more people saying I can’t do that than I have customers.
Look under the hood of any achiever and you will see stretch marks. Boundaries are meant to be broken and the doers of the world know it. The sound barrier was unbreakable until it was. The greatest politicians did what was said to be impossible. Using the United States as an example: Washington created a nation he was told could not survive; Lincoln preserved the same impossible union; Jackson defined federalism in an impossible way (my apologies to Native Americans); and Roosevelt conquered The Great Depression no one knew how to fix and then won a world war against an impossible foe. Can you imagine Churchill in the ‘darkest hour’ of WWII saying, “That’s a wrap, folks. Can’t be done. We’re fucked. Might as well quit.”
Early retirement and financial independence are considered impossible by a majority of people. “The dream is dead,” they say. “Can’t be done anymore.” Saving half your income is so radical most people can’t wrap their mind around it. They can’t fathom saving that much money so they think it is impossible. These people are goodie two-shoes. They do nothing wrong: no drinking, smoking, looking at seedy internet pictures, or breaking any laws. And they are all full of shit! And broke!
You don’t have to drink, smoke, live promiscuously, or flagrantly break the law to amount to something. Personally I would never smoke, including weed; don’t like it. No tattoos on me, either. If you twist the laws you might think I step over the line now and again. And I drink. Not every day, but often enough. My preference is whisky. Hey! I’m not perfect, but I am successful.
There is a difference between pushing boundaries and integrity, morals, and ethics. The trick is to know which boundaries to push. Steve Jobs speeding down the highway thinking the rules do not apply to him is one thing; robbing the liquor store at gunpoint is another. In business I must stretch the rules. For Christ’s sake I work in taxes. Do you know how fucked up the tax code is? If not, reference this blog post.
Some lines are never crossed. My integrity is sacred. I may push the envelope, but I will never betray Mrs. Accountant’s trust. I am faithful and intend to stay that way. Of course, I notice attractive women and let’s not forget the internet. Still, Mrs. Accountant is the only woman I will ever touch. Period.
In business the lines are always pushed. It is a survival technique. Trying new ideas, redefining a business model, even finding a tax loophole are important characteristics of a successful business owner. Misappropriating (also called stealing) client money is not.
Warren Buffett says he accepts mistakes made by managers, but he will be ruthless if there is a lapse in integrity. I agree. I sometimes do shitty things for the right reasons. Sometimes the things I did were right to do, other times not; hindsight is 20/20. These are mistakes only. The goal is always to help others improve or to further a worthwhile business or personal objective. Thinking back, I know I have also made errors in integrity. These are my ‘darkest hour’ moments. Most of us can claim the same. Here is the lesson in life:
Making mistakes do not define you; how you handle the mistake (or lapse of integrity) does.
Know the difference. It can be hard to know the difference at times. What sounds like a great idea at first can turn out poorly. Pushing the boundary and failing is not the problem; the problem is never trying in the first place. All economic problems are the result of refusing to push the boundary and grow. Saving the majority of your income and living on modest spending are a major push of the envelope for most. Some great ideas turn out okay even if you are wrong. What is the worst that can happen if you pay off all your high interest debt? Pay off the mortgage? Or max out your retirement accounts? Damnit! I hate it when I fail that way.
Three Felonies a Day
Harvey Silverglate published Three Felonies a Day: How the Feds Target the Innocent in 2009. Silverglate tells multiple stories of how the government intentionally uses vague laws to target innocent people, especially business owners. The book is must-read material. He calculated the average CEO commits three felonies a day without knowing it. Personally, I commit 7 or 8 because I am an over-achiever, but I digress.
Everything is a crime if the laws are twisted. Like the tax code, it is all open to interpretation. The courts define, redefine, and clarify laws daily. Nobody really knows what many of the laws are or what they mean. (It means what I say it means after the fact.)
The goodie two-shoes of the world commit just as many crimes as the normal people do. You are not better than the next guy. I am not encouraging criminal behavior. What I encourage is responsible boundary expansion. Businesses have a fiduciary obligation (in my opinion) to expand society and take risks. Too often we point fingers after the fact when a risk taken fails. We forget risk taking is how we got here. Imagine the first caveman making an excuse against the use of fire to cook dinner.
You are guilty; so am I. Who cares? Is this a Steve Jobs moment or a robbing the liquor store moment? Elon Musk and Jeff Bezos are redefining how our society shops, travels, spends, and lives. If they don’t expand the boundaries we will stagnate as a society. (Now that I think about it, it might explain a lot about our current economy.) Musk recently was accused of not disclosing a death in a Tesla vehicle when the autopilot was on and used incorrectly by the driver. Musk said it was not material; the feds are looking into it. It isn’t material! If the guy crashed while the radio was on and he was checking the radio versus watching the road, it is not the manufacturer’s fault. Don’t worry. The government will give Elon Musk the proctology exam he deserves. Don’t want to expand the economy too fast now, do we?
Gauging by some emails I get, people think saving half your gross income is a crime, too. Early retirement and financial independence is easier than ever today. You can live the life you choose. The district attorney will find fault no matter what you do. It is self interest for him. Therefore, you need to expand your horizons and stretch boundaries while maintaining your integrity. Honesty is the determining factor. If you are honest you have maintained your integrity, even if the truth hurts.
My guess is I broke 4, maybe 5, laws writing this post. I am very concerned. I used over half my over-achieving quota before breakfast. Guess I’ll spend the rest of the day as a goodie two-shoes.
In the course of my work I am frequently asked to place a value on a business a client wants to sell or acquire. There are several ways to determine value in such situations. Today we are going to focus on the value of listed companies (stocks). Warren Buffett has stated most people should drop their money into an index fund and let it ride. If you are like me you follow Warren’s advice, but invest a portion of your money in individual stocks anyway.
There are numerous books on Warren Buffett and his style of investing. These books glance over the process Warren uses, focusing on tidbits of advice Warren has given over the years. Reading Graham and Dodd’s Security Analysis exposes how difficult it can be to value a company. Since Graham and Dodd, our understanding of value creation has grown and Warren Buffett uses the new analysis tools in his investing style.
The best book on corporate valuation today is Valuation: Measuring and Managing the Value of Companies by McKinsey & Company. Normally I would ask you to run to your library, but this book is not available in most libraries. Another reason to invest in owning Valuation is the depth of the material. You will want to highlight as you read and make notes in the margin. You will come back again and again to this book as you consider investments.
Valuation is used as a textbook in many business schools. At over 800 pages you will want to take your time as you drink from the knowledge provided. I will share some of this information below, but want to outline a few different ways to purchase Valuation. I managed two hedge funds in the first decade of this century. Books like Valuation allowed me the opportunity to earn outsized returns.
There are three ways to buy Valuation. I provided the book cover image in this article three times explaining what each purchase involves. The first image is linked to Amazon to purchase only the book. This is what I use. The second image links to Amazon to purchase the book bundled with a workbook to help you learn and retain the information you are reading. The final image links to a bundled book with software. The software allows you to plug in information from an annual report and produces the information contained in Valuation. In short, the software eliminates the need to do the math yourself.
What is Value?
It is impossible to share the entire book with you here. Instead, I will show you a simple way to evaluate a company to determine if it is a good candidate for purchase. “Companies that grow and earn a return on capital that exceeds their cost of capital create value.” (Phrases in this article in quotations are direct quotes from Valuation.) Value is described in monetary terms. A company investing in research and development or capital equipment must earn a return greater than the cost of capital or they are destroying value.
“Creating shareholder value is not the same as maximizing short-term profits.” When Warren Buffett finds an undervalued company he does not expect the stock price to instantly reflect his perceived value after he buys it. As you will see shortly, value discovered takes time to reveal itself in the stock price. Warren Buffett’s greatest secret is patience. He buys great companies at a discounted price and waits as the company continues to increase value for shareholders.
Overemphasis on reported earnings is a poor way to discover value. Short-term profits can easily be inflated or manipulated. A manager may cut advertising or R&D, artificially inflating short-term results. Public corporations are notorious at stripping out certain expenses and listing them in notes in the annual report. Many wages are hidden in stock buy-backs. Public companies buy back their own stock only to issue it as options to management. The amount reported in earnings is less than the real cost to the corporation. The Earnings Report only provides a glimpse of a company’s income and expenses and is easily manipulated. The cash flow statement offers a better view of the company’s finances and exposes value creation or destruction.
“As a result of their focus on short-term EPS, major companies often pass up value-creating opportunities.” When you make your own investment decisions versus investing in an index fund you need to find companies with managers willing to forego short-term profits for long-term value creation. There are ample opportunities in the stock market to find undervalued companies working hard to create value. Short-term investors frequently avoid stocks based solely upon reported EPS. They pass companies growing real long-term value.
Return on Invested Capital
ROIC is the single most valuable tool investors like Warren Buffett use to discover hidden value. The ability of a company to invest capital and create revenue growth over a sustained period of time determines how much value management creates. As long as the ROIC is more than the cost of capital value is created. ROIC less than the cost of capital actually destroys value.
“Growth, ROIC, and cash flow are mathematically linked.” Reported EPS is not linked in the same manner. Cash flow will reveal ROIC and growth over time. Companies with a high ROIC do better when they focus on growth while low ROIC companies benefit from increasing their ROIC. Faster growth rarely fixes a ROIC problem.
Here is a real life example from the book. From 1985 to 2012, Walgreens and General Mills earned similar shareholder returns. Walgreens grew after-tax operating profits at 13 percent per year while General Mills grew 9 percent. Over this period Walgreens grew profits by 25 times whereas General Mills grew earnings only 9 times larger. “The reason General Mills could create the same value as Walgreens despite 30 percent slower growth, was that General Mills earned a 29 percent ROIC, while the ROIC for Walgreens was 16 percent.”
Without a positive rate of return on capital a company cannot grow or create value. The greater the sustained ROIC, the greater the value creation.
A simple illustration can help us visualize ROIC in action. From the book we will use the example of Value Inc. versus Volume Inc.
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues 1,000 1,050 1,102 1,158 1,216
Earnings 100 105 110 116 122
Investment (25) (26) (28) (29) (31)
Cash Flow 75 79 82 87 91
Revenues 1,000 1,050 1,102 1,158 1,216
Earnings 100 105 110 116 122
Investment (50) (53) (55) (58) (61)
Cash Flow 50 53 55 58 61
Value Inc. and Volume Inc. both have the same earnings and growth. Which company would you invest in? Which is creating more value? In our example, Value Inc. invests 25 percent of its profit while Volume Inc. needs to invest half of its profit to maintain the same level of profits growth. After five years, Value Inc. has nearly 50 percent more cash flow than Volume Inc. Volume Inc. is required to invest half its profit to maintain the same growth as Value Inc. This is why reported earnings do not tell the whole story and it is a wonder why so much emphasis is placed on that single number.
The ROIC is significantly different between the companies. A $25 investment produces a $5 increase in profit for Value Inc. while Volume Inc. invests $50 for the same return. Here is the math that ties Cash flow, growth, and ROIC together:
Growth = ROIC x Investment Rate
Value Inc. looks like this:
5% = 20% x 25%
And applying the formula to Volume Inc. is as follows:
5% = 10% x 50%
Volume Inc. needs a higher investment rate to accomplish the same growth.
Another consideration is the discounted value of future earnings. Time value of money and risk make future earnings worth less than current earnings. Investments made today fuel future earnings. Today’s investments lose their power as time depreciates equipment and new products (internally and from competitors) reduce the value of the investment.
There is a model in Valuation that helps further clear the fog around the math on value creation. I will not delve deeper into that math in this blog post. I do want to add one more piece to the above example of value creation, however. Let us assume Value Inc. was able to invest 40 percent of profits (instead of 25 percent) with the same ROIC. Should management engage such an endeavor? It depends if you are a short-term or long-term investor. If management does decide to make the additional investment, cash flow will be lower the first eight years, equal in year nine and higher in year ten and later. Reported profit will be higher each year, but cash flow will be lower in the early years. Dividends and share buy-backs are paid for from cash flow or borrowed money. So less cash flow will restrict dividends early in the investment, while higher cash flow in year ten and after provide more funds for dividends, share buy-backs, or more investment. There is the added risk an investment will not perform as planned.
Mature industries are easier to gauge than upstarts. Investing for the higher ROIC makes sense, but you also need to consider the industry. When searching for a company to buy you want to start with strong industries. Buying the best company in a strong industry provides a margin of error for any miscalculations. Not every bank will be a great buy. The strongest bank with the highest ROIC will probably continue to outperform its peers.
Management is also important. A management team with a reputation for performance is a powerful inducement for investment. However, when a management team’s reputation and a poor industry meet, the poor industry will win, producing poor results. Higher ROIC companies also command a higher price/earnings ratio. The PE ratio and reported earning only provide a check on your research. Using only reported earning in your investment decision making will require luck to win (and I don’t have much faith in luck).
By applying these methods of research it is possible to generate an outsized rate of return on your investments. You can beat the market and have one huge advantage over Warren Buffett: Warren Buffett needs to invest massive amounts of money to move the needle; you can invest a small amount in a small company where Warren Buffett cannot.
It is unfortunate when management games ROIC by cutting investment to artificially increase current stated EPS. By riding on past investments, poor managers can provide short-term results. Before long the price is paid as growth from past investments declines. In your research you need to beware of such foolish activities by a company. A company increasing investment with a solid ROIC will create value. Your research should always include several years of data to see the level of investment made each year and how productive that investment was.
The final rule is patience. Every business has its ups and downs, even good companies with high ROIC. The stock price will not immediately reflect its underlying value the day after you buy the company. Value is frequently revealed in layers, year after year, as quality investments compound excessive ROIC. More cash flow for the company means more value for you, as the shareholder.
Remember, “Value is driven by expected cash flows discounted at a cost of capital. Cash flow, in turn, is driven by expected returns on invested capital and revenue growth. Companies create value only when ROIC exceeds their cost of capital.”
As we finish this post, let’s engage in an experiment. Last week I bought a small number of shares in Netflix at $95.63. It is the first stock purchase I made this year. The stock was down after forward guidance by management disappointed. With information easily available online, discuss why you think I found Netflix a company worth buying? Why did I buy such a modest number of shares? My investment horizon is always years and decades, not weeks or months. If Netflix continues to fall I will buy a few more shares.
In the comments below discuss why you think I invested in Netflix the way I did. I will chime in periodically on comments with my thought process on this single investment. To prod the discussion, think about a few Netflix facts. Netflix recently entered 130 new countries (investment). Their earnings, cash flow, and growth do not reflected this investment because they just made the investment and will continue investing in this arena. Also think about margin of error and what could go wrong. Most of all, have fun.
More interesting books on investing and Warren Buffett.