Earnings growth happens three ways and they are of vastly different quality. The best kind of growth is organic top line unit growth. Companies that grow by doing more of whatever they do are the most valuable. Investors, can, should and do pay up for this kind of growth.
The next best type of growth is through margin expansion. Margin expansion is good. It rarely requires additional capital. Whether it comes from pricing power, economies of scale or cost cutting it is nice. The problem with margin expansion versus, unit growth, is it isn’t open ended. Most businesses can only improve margins to a certain extent. Eventually, they can’t push price, they operate at optimal scale and there is no fat left
The third way, and least valuable, to create earnings growth is by leveraging the balance sheet. Sometimes this passes as top line growth through acquisitions or excess capital investment. Sometimes it comes from leveraged recapitalizations through one means or another or incrementally over time through share repurchases. However achieved, this form of earnings growth is least valuable. Not only is it inherently unsustainable – the growth rate, not the earnings – in that companies can only leverage to a certain degree, but such growth should be rewarded with a shrinking p/e multiple as the risk to the enterprise grows and the cost of equity correspondingly should increase.
It is true that sometimes the market doesn’t recognize the distinction and rewards this growth with an undeserved rich multiple. However, that is a difference between what the market should do versus what it does do. Smart investors can make the distinction and avoid paying up for situations like these where higher growth comes with higher risk.
On Health care companies. Key checklists to take note
- Does the company deliver better quality care than someone can get anywhere else?
- Does the company deliver a net savings to the overall health care system?
- Does the business produce high returns on capital, have growth potential, and have shareholder friendly management?
On the 3 types of businesses
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and
continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great.
(A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.)
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no
rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly
great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large
portion of their earnings internally at high rates of return.
Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates
industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.
We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business.
In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire
There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow.
When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.)
Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.
Consequently, if measured only by economic returns, FlightSafety is an excellent but not
extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.
Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires
significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.
The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
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