I've noticed three common themes with Buffett's recent investments in energy and Japan: low valuations, improving capital allocation, and rising ROIC's.
John - thought this article was so interesting, particularly the reference to Marathon Asset and idea that stocks with low asset growth tend to be the best performing. I went back and looked at OXY and CVX’s total assets and numbers are flat/declining over past several years. Very helpful in understanding what may be driving Buffett’s view of these companies -- he also obviously likes aggressive buybacks by both companies.
Also went and looked at BRK’s total assets -- growing steadily while share count goes down due to buybacks. BRK’s equity still growing despite buybacks. Love BRK’s trends: EPS going up due to buybacks and FCF growth; assets and equity up due to reinvestment (despite buybacks); and FCF steadily going up on a growing asset base. Maybe returns on incremental invested equity aren’t optimal (although equity returns look good after backing out excess cash and unrealized gains on BRK’s public equity investments and adding look through earnings to BRK’s returns), but the reinvestment runway looks decades long with lots of internal compounding in the future.
Thanks Bill. Yes, I think Buffett is attracted to the stable/declining assets in oil simply because that has led to increasing ROIC's. That combo of producing same (or more) earnings with the same (or less) capital is really powerful. It doesn't attract as much attention as growth, but it can be just as valuable because it frees up more and more cash to be returned via buybacks. And if the stock is cheap (let's say a 20% FCF yield), that combo is effectively creating a 20% reinvestment engine.
On BRK: assets are growing, but there are exceptions to the rule. Just like a basket of low P/E stocks will generally outperform a basket of high P/E stocks, a basket of high asset growth companies tend to underperform, but there are exceptions (WMT, HD, SBUX and many others had steadily rising assets but the ROIC's never mean reverted (or didn't for many years). BRK has the best all-time capital allocator so in that case you want rising assets because you know they'll be put to good use.
Thanks for reply John — always appreciate your insights! Really like how BRK’s FCF and look through earnings keep marching upward — sometimes bumpy but generally upward. Also like how they have lots of choices re acquisitions, buybacks, and reinvestment in internal subs (Taleb notes that optionality promotes resilience/antifragility). Don’t want the dividends or taxes and hope to continue deferring cap gains on BRK. Size/strength of insurance biz also seems like huge moat (not to mention return benefits of cost-free float).
In a nutshell: love a decades-long reinvestment runway with a steadily growing equity/asset base and consistently solid ROE’s — if purchase price is reasonable then after 20-30 yrs you end up with an excellent result. Should have studied a compound interest table a lot sooner.
One other thing that just occurred to me — if the asset base for a company is consistently shrinking (e.g., CVX or OXY), then at some point you’d expect that to cause shrinkage in revenues and FCF, ultimately leading to a decline in future discounted FCF’s and a reduced PV — and market value — for the company as a whole. I suppose a company could try and offset this impact by aggressively repurchasing shares so that the company’s per share intrinsic value (its PV on a per share basis) increases despite declining future FCF’s. So in this situation the PV and market value of the entire company could be declining while the per share intrinsic value and per share market price could be going up. Whew — a bit confusing! Thanks again!
Last comment I promise! Maybe one key to Marathon’s investment approach is assets that are growing slowly, flat, or declining slowly, allowing company to take full advantage of high ROICs and low stock price to make repurchases over an extended time period. If the asset base is shrinking too rapidly then revenues and FCF may be contracting too rapidly as well (meaning repurchases won’t offset the decline in FCF enough to increase per share intrinsic value). I also think of Henry Singleton’s approach (and Apple’s approach as well) — using cheap fixed rate debt to finance the aggressive repurchase of undervalued shares (without accompanying asset shrinkage) — the best of all worlds. Sorry for all the rambling!
Great article as always, John. Loved the thoughtful and thorough coverage of all the value levers, not just growth. As I was reading, I found this section somewhat confusing, maybe there is a typo here:
Under "3 Types of Rising ROIC's," you said, "1 — increasing the denominator (reinvesting all capital into the business at high rates of return)."
I am guessing you meant "increasing the numerator for a unit of additional capital deployed" because the sentence seems to indicate ROIC would go up with a higher denominator which is clearly not the case.
Hi Murali, yes I need to reword that language. It isn't clear, but what I meant in #1 is you can increase the ROIC by reinvesting capital (increasing the denominator) at higher rates of return than the historical ROIC (increasing numerator). If FND's historical ROIC is 20% and they're reinvesting all earnings into new stores at 30% returns, then the ROIC is going to rise. What I should have said is simply: 1) a company can increase returns through reinvesting into the business at higher rates of return (reinvestment); 2) getting more profit out of the existing assets (more profit on the same level of capital investment), or 3) same level of profit on a shrinking level of capital.
"For example, a stock that grows earnings at 5%, has a P/E go from 8 to 12 over a 5 year period, and returns all its earnings via buybacks and/or dividends will provide you with approximately 23% total annual returns over that 5 year period. Growth engine gave you just 5%, but you received an 8.4% annual tailwind from the P/E multiple and approximately 10% additional returns from buybacks and dividends."
I was wondering how you came up with "23% total annual returns". If we assume that all earnings are returned via dividends, then the IRR is 25.3%. If earnings are returned via buybacks, then the IRR is determined by what valuation the stock is repurchased at. I guess when you calculated 23%, you assumed earnings were returned via buybacks and these buybacks were done at a P/E of 12? This give you an IRR of 23.4%.
With buybacks you can get pretty much any IRR you want since there is path dependency on the stock price. I think dividends are a lot cleaner for this sort of analysis.
It's an estimate. Yes, correct that share count depends on valuation (lower price = better future returns since you can eat in more shares). In the example above, if the P/E goes from 8 to 12, you can assume an average somewhere in that range for the price paid. The nice thing about buybacks is if the stock stays cheap, you're going to eat in a lot of shares; if the stock's P/E gets expensive, you can always sell the stock and it advances your return faster.
Additionally, a company with a high free cash flow yield and aggressive buyback strategy can offer a unique advantage: reduced risk of operational mistakes. While reinvesting earnings into the business can generate growth, it often involves higher uncertainty— because you have to decide and evaluate new projects or expansions. And these decisions may not deliver the expected returns. In contrast, the capital allocation strategy of buying back shares is straightforward, immediately accretive to earnings per share, and provides tangible value to shareholders. This stability, combined with the potential for valuation multiple expansion, can create a powerful compounding effect, offering an appealing blend of growth and downside protection for investors. Buffet knows what he is doing, for sure! Great post!
Hi John, very well articulated article! I particularly enjoy your ability to distill the concepts of ROIC into a palatable form of content. Could I ask what the title of the book was in reference to the Movie Industry?
JP, pasting what I said in another comment thread.
The tradeoff is profit margin. Using options cedes margin but increases ROIC. One is not necessarily better than the other. depends on execution, relationships with developers, land prices, etc… NVR margin lags when land values are rising, but they also take less risk and generate more free cash
In short, owning land isn't necessarily good or bad but in most cases it does require more capital which usually (not always) leads to lower returns on capital. PHM has made a concerted effort to shift their business model away from owning land, basically wanting to make that tradeoff of giving some margin for increasing returns on equity and lowering the risk.
Hi John, I hope you're doing well. Massive fan of your Substack/Twitter.
I am a founder of Zeed (https://zeed.ai/). We're helping creators transform their written content (like this Substack) into dynamic video pieces using AI to capture new audiences.
Would love to show you an example and jump on a call if you're interested in hearing more! Best, Rohan.
Very insightful post. Thanks for fleshing these ideas out fully. While it may be known that buybacks can propel gains, this laid it out very clearly and logically.
John - thought this article was so interesting, particularly the reference to Marathon Asset and idea that stocks with low asset growth tend to be the best performing. I went back and looked at OXY and CVX’s total assets and numbers are flat/declining over past several years. Very helpful in understanding what may be driving Buffett’s view of these companies -- he also obviously likes aggressive buybacks by both companies.
Also went and looked at BRK’s total assets -- growing steadily while share count goes down due to buybacks. BRK’s equity still growing despite buybacks. Love BRK’s trends: EPS going up due to buybacks and FCF growth; assets and equity up due to reinvestment (despite buybacks); and FCF steadily going up on a growing asset base. Maybe returns on incremental invested equity aren’t optimal (although equity returns look good after backing out excess cash and unrealized gains on BRK’s public equity investments and adding look through earnings to BRK’s returns), but the reinvestment runway looks decades long with lots of internal compounding in the future.
Thanks again for your efforts!
Thanks Bill. Yes, I think Buffett is attracted to the stable/declining assets in oil simply because that has led to increasing ROIC's. That combo of producing same (or more) earnings with the same (or less) capital is really powerful. It doesn't attract as much attention as growth, but it can be just as valuable because it frees up more and more cash to be returned via buybacks. And if the stock is cheap (let's say a 20% FCF yield), that combo is effectively creating a 20% reinvestment engine.
On BRK: assets are growing, but there are exceptions to the rule. Just like a basket of low P/E stocks will generally outperform a basket of high P/E stocks, a basket of high asset growth companies tend to underperform, but there are exceptions (WMT, HD, SBUX and many others had steadily rising assets but the ROIC's never mean reverted (or didn't for many years). BRK has the best all-time capital allocator so in that case you want rising assets because you know they'll be put to good use.
Thanks for reading!
Thanks for reply John — always appreciate your insights! Really like how BRK’s FCF and look through earnings keep marching upward — sometimes bumpy but generally upward. Also like how they have lots of choices re acquisitions, buybacks, and reinvestment in internal subs (Taleb notes that optionality promotes resilience/antifragility). Don’t want the dividends or taxes and hope to continue deferring cap gains on BRK. Size/strength of insurance biz also seems like huge moat (not to mention return benefits of cost-free float).
In a nutshell: love a decades-long reinvestment runway with a steadily growing equity/asset base and consistently solid ROE’s — if purchase price is reasonable then after 20-30 yrs you end up with an excellent result. Should have studied a compound interest table a lot sooner.
One other thing that just occurred to me — if the asset base for a company is consistently shrinking (e.g., CVX or OXY), then at some point you’d expect that to cause shrinkage in revenues and FCF, ultimately leading to a decline in future discounted FCF’s and a reduced PV — and market value — for the company as a whole. I suppose a company could try and offset this impact by aggressively repurchasing shares so that the company’s per share intrinsic value (its PV on a per share basis) increases despite declining future FCF’s. So in this situation the PV and market value of the entire company could be declining while the per share intrinsic value and per share market price could be going up. Whew — a bit confusing! Thanks again!
Last comment I promise! Maybe one key to Marathon’s investment approach is assets that are growing slowly, flat, or declining slowly, allowing company to take full advantage of high ROICs and low stock price to make repurchases over an extended time period. If the asset base is shrinking too rapidly then revenues and FCF may be contracting too rapidly as well (meaning repurchases won’t offset the decline in FCF enough to increase per share intrinsic value). I also think of Henry Singleton’s approach (and Apple’s approach as well) — using cheap fixed rate debt to finance the aggressive repurchase of undervalued shares (without accompanying asset shrinkage) — the best of all worlds. Sorry for all the rambling!
Great article as always, John. Loved the thoughtful and thorough coverage of all the value levers, not just growth. As I was reading, I found this section somewhat confusing, maybe there is a typo here:
Under "3 Types of Rising ROIC's," you said, "1 — increasing the denominator (reinvesting all capital into the business at high rates of return)."
I am guessing you meant "increasing the numerator for a unit of additional capital deployed" because the sentence seems to indicate ROIC would go up with a higher denominator which is clearly not the case.
Thanks again for a writing a wonderful article.
Hi Murali, yes I need to reword that language. It isn't clear, but what I meant in #1 is you can increase the ROIC by reinvesting capital (increasing the denominator) at higher rates of return than the historical ROIC (increasing numerator). If FND's historical ROIC is 20% and they're reinvesting all earnings into new stores at 30% returns, then the ROIC is going to rise. What I should have said is simply: 1) a company can increase returns through reinvesting into the business at higher rates of return (reinvestment); 2) getting more profit out of the existing assets (more profit on the same level of capital investment), or 3) same level of profit on a shrinking level of capital.
Thanks for the comment!
Great post!!! Thank you!
"For example, a stock that grows earnings at 5%, has a P/E go from 8 to 12 over a 5 year period, and returns all its earnings via buybacks and/or dividends will provide you with approximately 23% total annual returns over that 5 year period. Growth engine gave you just 5%, but you received an 8.4% annual tailwind from the P/E multiple and approximately 10% additional returns from buybacks and dividends."
I was wondering how you came up with "23% total annual returns". If we assume that all earnings are returned via dividends, then the IRR is 25.3%. If earnings are returned via buybacks, then the IRR is determined by what valuation the stock is repurchased at. I guess when you calculated 23%, you assumed earnings were returned via buybacks and these buybacks were done at a P/E of 12? This give you an IRR of 23.4%.
With buybacks you can get pretty much any IRR you want since there is path dependency on the stock price. I think dividends are a lot cleaner for this sort of analysis.
It's an estimate. Yes, correct that share count depends on valuation (lower price = better future returns since you can eat in more shares). In the example above, if the P/E goes from 8 to 12, you can assume an average somewhere in that range for the price paid. The nice thing about buybacks is if the stock stays cheap, you're going to eat in a lot of shares; if the stock's P/E gets expensive, you can always sell the stock and it advances your return faster.
Additionally, a company with a high free cash flow yield and aggressive buyback strategy can offer a unique advantage: reduced risk of operational mistakes. While reinvesting earnings into the business can generate growth, it often involves higher uncertainty— because you have to decide and evaluate new projects or expansions. And these decisions may not deliver the expected returns. In contrast, the capital allocation strategy of buying back shares is straightforward, immediately accretive to earnings per share, and provides tangible value to shareholders. This stability, combined with the potential for valuation multiple expansion, can create a powerful compounding effect, offering an appealing blend of growth and downside protection for investors. Buffet knows what he is doing, for sure! Great post!
Hi John, very well articulated article! I particularly enjoy your ability to distill the concepts of ROIC into a palatable form of content. Could I ask what the title of the book was in reference to the Movie Industry?
Great write up!
I wish i came across these in 2016
Many make a case for NVR bc it doesn’t own land compared to other home builders. Is land ownership by PHM a detriment?
JP, pasting what I said in another comment thread.
The tradeoff is profit margin. Using options cedes margin but increases ROIC. One is not necessarily better than the other. depends on execution, relationships with developers, land prices, etc… NVR margin lags when land values are rising, but they also take less risk and generate more free cash
In short, owning land isn't necessarily good or bad but in most cases it does require more capital which usually (not always) leads to lower returns on capital. PHM has made a concerted effort to shift their business model away from owning land, basically wanting to make that tradeoff of giving some margin for increasing returns on equity and lowering the risk.
Thank you
Great post! I really enjoy your opinion on buybacks and how you've explained them to the reader.
Way to go📈
Hi John, I hope you're doing well. Massive fan of your Substack/Twitter.
I am a founder of Zeed (https://zeed.ai/). We're helping creators transform their written content (like this Substack) into dynamic video pieces using AI to capture new audiences.
Would love to show you an example and jump on a call if you're interested in hearing more! Best, Rohan.
Very insightful post. Thanks for fleshing these ideas out fully. While it may be known that buybacks can propel gains, this laid it out very clearly and logically.