Buffett's 44% CAGR and Various Types of High Quality Investments
I've noticed three common themes with Buffett's recent investments in energy and Japan: low valuations, improving capital allocation, and rising ROIC's.
Warren Buffett initially invested in 5 Japanese stocks in 2020 and I don't think many people realize how successful this investment has been so far:
That initial basket investment is up over 200%: a 3x in 3 years, or 44% CAGR on that initial investment. Each stock is up over 2x, one is up 5x, and the basket in aggregate up 3x. He's added to the basket since, and those add on purchases have also done well. This post is not necessarily a pitch on Japanese stocks. My goal here is to outline some common themes with some of Buffett's recent investments in Japan and energy, and to illustrate why I think he's finding lots of interesting value in those areas.
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Common Themes of Good Businesses
Just like how we would rate an investment result, a good business is one that makes a lot of money relative to the money that you had to put into it (i.e. high return on capital).
But the most value gets created in companies that see increasing returns on capital (i.e. high incremental returns on capital; e.g. a company where returns rise from 12% to 18%, etc...). I've spent a lot of time thinking about Buffett's investments in Japan (which is now a top 5 investment) and also in energy (which is his largest equity investment behind Apple). The common theme is something that might surprise most people and I think probably isn't fully appreciated: both groups have rising returns on capital.
I see three things that Buffett probably saw (among other things) in Japan and also in energy:
Significant change in capital allocation policies
(These traits also applied to Apple when he first invested in 2016). Buffett has always prioritized value. We know he has a preference for quality companies but he's always been a value focused investor who wants a high FCF yield (more so than Munger). He has said "price is my due diligence" and we know from both his words and actions (especially in the earlier years) that he prefers quality, but he demands value.
But, he also wants quality businesses. And despite the stodgy historical returns, these groups are exhibiting current ROIC's that exceed those of most of the FANG stocks and other high fliers. And not just better ROIC's but also more rational capital allocation. There isn't much growth in his Japanese trading companies, but if you pay 7x FCF for a stock that is returning all of that FCF via buybacks and dividends, you earn a 15% annual return even with no growth and no increase in the multiple.
I've written about 3 engines: a stock's return is the product of three simple factors: growth, change in multiple, and capital returns (change in shares outstanding plus any dividends). Over the past decade, many investors focused on the first engine exclusively, ignoring the 2nd and 3rd. This worked over the last decade, but I would not expect it to work going forward. Growth is an important input into value, but it is just one of those three engines. If you pay too much, engine #2 becomes a drag (P/E contraction). If you own a stock that's diluting through share issuance, engine #3 is a drag. It's possible to earn high returns from one engine that overcomes the other two, but this is rare.
The best stocks often have all three engines working — sometimes only in surprisingly modest amounts individually, but collectively they can produce fabulous results. 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.
This simple math shows the reality of why it's so important to think about value (P/E) in addition to quality (ROIC and growth).
But one thing Buffett seems to prioritize most is capital allocation. In the Japanese stock case, we're seeing a major change in strategy that encourages more focus on increasing ROE through buybacks and dividends. I listened to the old BRK AGM's and heard Buffett say in the early 2000's that he wasn't interested in Japan despite there being cheap stocks. The ROE was too low. Difference now? A big change in capital allocation. I'm reading numerous annual reports there that explicitly state a completely new philosophy on capital.
Buffett’s Japanese companies have recently been increasing their buybacks and dividends, and this should drive ROE higher in the coming years. His main energy investment: Occidental Petroleum has reduced its assets by 30% over the past 4 years, while increasing FCF, buybacks, and dividends. Rising returns on capital are often associated with growth, but they also can come from increasing levels of free cash flow per dollar of capital invested (more on this below).
Asset Growth and Returns on Capital
There is also a bit of capital cycle theory going on here where money isn't entering some of these industries and in some cases its leaving, and when supply of capital declines, competition trends become favorable, which increases ROIC, all else equal.
In the Marathon Asset Management book Capital Returns, they cite an interesting study that directly links asset growth to poor stock price results. Like any quantitative basket, there are lots of individual exceptions, but in aggregate: the best performing stocks have low asset growth; the worst stocks have high asset growth.
Industries sometimes have very long cycles where returns rise, competition increases, which lowers returns, driving out capital and leaving the remaining players better positioned. I recently read a book that outlined in detail the history of the movie theater industry, which has had a few different periods lasting multiple decades where returns were either quite good or quite poor. Drive-in theaters were once a fast growth industry in the 1950's and early 60's where early players made fortunes, but little barrier to entry led to far too much competition, which crushed returns and forced many companies out of business. This led to a long period of poor returns, until over time, modest population increases and steady demand for entertainment finally soaked up excess supply. This allowed a few remaining players (including Sumner Redstone’s National Amusements) to earn nice returns for a couple more decades until the 1990's when competition again heated up and everyone built giant multiplexes with 20 screens or more (today's modern theaters), leaving the industry far oversupplied with too many screens and too much fixed costs, leading to bankruptcies and restructuring. Demand growth has been remarkably sticky (contrary to narratives). It’s supply that has fluctuated far too much.
The industry has muddled along since then with very low growth and mediocre returns. Theaters didn't grow but spent money refurbishing existing locations with comfy reclining seats, hoping to extract some better pricing power and higher returns on their assets, and then Covid hit, which probably put the final nail in the coffin for any appetite to add new capital to this industry. While most commentary I've read focuses on demand trends for moviegoing, what is missed is the absolute lid on supply growth, which could lead to a long period of rising returns on capital (as measured not through growth but through high free cash flow with no new capital investments). Some companies have risky, overleveraged balance sheets (AMC and Cineworld) and have no ability to invest even if they wanted to. One of those is in bankruptcy and the other will have a hard time avoiding it. But this is great for the supply situation and leaves an opening for the best management teams (CNK) with the best balance sheets and highest free cash flow to increase cash returns.
Low asset growth, higher quality earnings (i.e. more free cash flow), very low valuations, and a renewed interest from all the major studios to retrench back from streaming only to theatrical releases (see Barbenheimer as evidence of theatrical marketing value for IP) — all of this could lead to rising returns on capital and durable free cash flow — which could lead to high value creation even with low single digit growth.
It’s critical to remember: companies with high ROIC’s + low growth (by definition, high FCF generation) + consistent buybacks will benefit if their P/FCF is low and stays low forever. This is another misunderstood point in conversations I have with people: everyone is focused on either growth (engine 1) or multiple (engine 2) but forget about capital returns (engine 3) and how low valuations enhance returns (lower multiple means higher value creation per share).
The point here isn't to suggest any specific stock or industry. I'm just using theaters as an example of an industry that has seen multi-decade periods of rising and falling (and rising again) ROIC's.
My point here: good companies tend to have improving ROIC's (high incremental returns).
Remember: a good business isn't one that has an interesting or exciting narrative, it's one that makes a lot of money relative to the money invested into it. Buffett obviously doesn't get influenced by narratives or growth stories. He's only interesting in finding great investments. And great investments tend to come from good businesses that are undervalued. And good businesses tend to have two common themes: strong returns on capital and good management that are rationally allocating free cash flow. Japanese stocks and energy stocks lack exciting narratives, but they have these key ingredients that are found in most quality investments: good returns on capital, smart capital allocation, and low valuations. All three engines are working in these two investment areas for Buffett. I think this is what interested him in Apple, it is what interested him in Japan and energy, and it is what has led these investments to become so successful.
3 Types of Rising ROIC's
Rising returns on capital simply means more earnings per unit of capital invested. These rising ROIC's can happen in three ways:
1 — increasing the capital invested in the business (reinvesting earnings) while earning a higher return on those investments; both the profit and the capital invested grows, resulting in a much larger business over time; this is what I call “phase 1” companies in the earlier part of their growth trajectory: e.g. FND’s current business model; ROIC here benefits from the high returns they get on the new stores (30%+) in addition to the natural sales and operating improvements at existing stores
2 — increasing the productivity on an existing level of capital investment; this means getting more profit on the same level of capital investment: these are “phase 2” businesses; e.g. HD hasn’t increased its store count in 15 years, but its ROIC has steadily risen over time thanks to ever increasing store productivity (more units sold at higher per unit prices means more profit without any major new capital investments)
3 — but most surprising to most people — a similar value creation can also come from a shrinking denominator while keeping earnings flat — reducing excess cash levels through buybacks (which reduces the denominator). This means no growth but increasing quality of earning power, which frees up more and more cash to be used for buybacks. This can be especially effective when the rising FCF occurs on stocks with low multiples, as the company can gets a better return (higher FCF yield) on its own shares.
In short, quality returns on capital can come from reinvestment engines or from cash cows that trade at low valuation levels. A company that earns 20% returns on capital and can reinvest all of its earnings will grow earnings per share at 20%. But a company with 0% growth that trades at 5x FCF (20% FCF yield) and is using the cash to buy back shares will also compound earnings per share at 20%. In some cases, this latter stock is more attractive because of the potential for a dramatic increase in valuation levels (if the P/E goes from 5 to 15 over a decade, that’s a 12% per year tailwind before accounting for any growth in earnings or any benefit from stock buybacks).
The reinvestment engines are truly wonderful businesses, but they are exceedingly rare (most have fleeting returns on capital because there isn’t a strong enough moat to defend against competition that wants a piece of those returns. More common are stocks like Pulte Homes (PHM) — there isn't exciting growth or a popular narrative, but PHM has compounded value for owners at 20% annually over the last decade thanks to a rising return on capital that came not because of reinvestment into more growth, but from rising quality of earnings, freeing up lots of cash flow to be returned to owners (PHM reduced its share count 43% over the last decade).
Earnings aren't shown here, but they grew faster than assets, which only grew modestly. The result is increasing ROIC not from reinvestment (asset growth) but from productivity (earning more money on same amount of assets). This frees up cash for buybacks. The result is PHM compounded value per share at 20%, faster than many well-known compounders, despite only modest asset growth.
All three scenarios above lead to similarly strong returns on capital and value creation. And while it's preferable to own a business that can reinvest at high rates for decades, the second and third category can also lead to similarly exciting results for owners because businesses in these categories often exist in industries where capital is leaving (which tends to keep a lid on competition and allows for excessively high ROIC's to continue). All three scenarios need a business with a moat, and all three can create value (albeit using different parts of the “3 engines”).
My observation is stocks in the 2nd and 3rd groups are more often undervalued because they lack exciting growth (even though their ROIC’s and valuation creation are just as strong). This provides an opportunity: the quality of their business (high ROIC) coupled with low valuations lead to enormous ability to create value through consistent buybacks at cheap levels (see NVR or AZO in my previous post).
Quality companies and moats come in all shapes and sizes. But, like dollars, ROIC's are fungible. Investment returns are fungible. They can come from high returning reinvestment or from low valuation cash cows that have no need for more capital (both can compound value per share at similar rates). A good business — like a good investment — is one that makes a lot of money relative to the money you put into it.
One of many things that has made Buffett a special investor is he looks at the facts and ignores the narratives. I think this method allows you to be open minded and receptive to quality investment ideas, wherever they might be.
Disclosure: Saber Capital Management owns stock in FND, CNK, NVR and PHM. These are not recommendations. The goal of this post is solely for explaining investment concepts for educational purposes. Please conduct your own due diligence.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at firstname.lastname@example.org.
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