ROIC And Returns

Warren Buffett discussed his Kraft Heinz mistake with Becky Quick. While he still views Kraft Heinz as a wonderful business, he paid too much. Here is a screenshot of the transcript:

Source: https://www.cnbc.com/2019/02/25/full-transcript-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

Investors often say that overtime your returns will converge with the business’ returns. As Buffett mentions above, that is simply not true. What is true, however, is your returns converge with the underlying business when you purchase a business and it grows substantially following your purchase. The higher the entry price, the more the business has to grow in order to provide the owner with the business’ underlying economics.

The reason is simple. As an owner/partner, you earn your proportionate economics on the earnings a business generates. However, each partner has a different entry price based on a different earnings base (depending on when they purchased shares and/or LP interests). Therefore, each owner/partner is entitled only to his/her purchase yield on the base he/she acquired. Following the purchase, however, an owner’s economics on the incremental earnings base mirrors the underlying economics of the business.

Kraft cannot grow the earnings base Buffett paid for. Thus, he is stuck (for now) earning $6Bn on his $100Bn purchase price. His economics will only improve if KHC (1) repurchases shares when they yield more than 6% on the enterprise (he is effectively averaging down in that transaction), (2) grows again and is able to earn more than $6Bn pretax without needing to raise additional equity, or (3) successfully executes an accretive acquisition.

As the greatest of all time shows, price is extremely important on slow growing businesses. More importantly, he provides some clarity on an often misunderstood investing idea.

Note: This discussion assumes Buffett purchased Kraft with 100% equity. That’s not factually accurate. Financing decisions can change the specifics of the discussion above, but the points made above are accurate for teaching purposes.

The importance of ROIC and Growth

I’ve seen a lot of discussion lately about whether low ROIC businesses are better than high ROIC businesses.  ROIC means “Return on Invested Capital.”  There are a couple different ways you can define invested capital but for these purposes I am going to borrow Joel Greenblatt’s definition and call it PP&E + Working Capital.  I will note, however, that I also deem any additional necessary assets or liabilities as part of invested capital.  For instance, an airline has many assets via lease.  These are obviously necessary to the airline’s operations and therefore cannot be excluded from an invested capital discussion (an offsetting adjustment to add back rent and subtract hypothetical depreciation would be necessary in this instance).

Anyway, many people say high ROIC businesses are inherently better investments over the long term than low ROIC businesses.  Why is this?  Well, it is because a business with high ROIC tends to grow earnings per share faster than a low ROIC business BECAUSE there is not a need for reinvestment.  As Warren Buffett says, you dont want to own a business that consumes all of its capital and has none to pay back to its shareholders.  Instead, the perfect business can earn capital, require no additional investment and (a) invest that money back into marketing or some other channel to grow sales or (b) return the capital to shareholders.  Why? Because all of the cash is cash for the owners rather than cash for the business then the owners.

That said, there is nothing inherently superior to a steady state high ROIC business and a steady state low ROIC business.  Why?  Because if you are paying a multiple of earnings then the income statement will already reflect the cost of depreciation (and consequently your reinvestment rate, assuming the firm is run well) in both firms.  Therefore, the multiple you pay will be much more important to determine your success as an investor in a steady state firm.

However, nothing in this world is steady state.  Ideally you are looking at a firm that is growing.  And in a growing firm, take a look at the following (elementary) example.

Screen Shot 2018-11-08 at 3.53.43 PMAs you can see, the earnings growth rate of the firm has grown by 31.6% in each instance.  HOWEVER, the free cash flow distributable to the firm grew by 2.6 more units in the firm that requires no incremental capital.  If we assume a 5% free cash flow yield on this investment, the firm that requires no incremental capital to grow its earnings base will be worth 52.6 units more than the firm that requires capital.  Which is just to say that no incremental capital, combined with growth, can be an incredibly powerful force that lifts the value of your investments.  Hence the reason software firms are worth so much more than industrial firms.