1987 Berkshire Letter and Buffett's Thoughts on High ROE _ Base Hit Investing

6/1/2014 1987 Berkshire Letter and Buffett's Thoughts on High ROE | Base Hit Investing

http://basehitinvesting.com/1987-berkshire-letter-and-buffetts-thoughts-on-high-roe/ 1/23

1987 Berkshire Letter and

Buffetts Thoughts on High

ROEBy John Huber On February 20, 2014 18 Comments

I am in the midst of writing a few posts on the importance of Return

on Invested Capital (ROIC). I wrote two posts last week discussing

Greenblatts formula and some thoughts on the topic (Here and

Here). Ill have one or two more posts next week discussing a few

brief examples of compounders (companies that exhibit

unusually high returns on capital over extended periods of time,

allowing them to growor compoundshareholder value over

long periods of time).

There always seems to be a strong divide between value and

growth, deep value (aka cigar butts) and quality value, etc I too

have mentioned these differences numerous times. And its true that

many investors can do well simply buying great businesses at fair

prices and holding them for long periods of time, while other

investors prefer to slowly and steadily buy cheap stocks of average

quality and sell them as they appreciate to fair value, repeating the

process over time as they cycle through endless new opportunities.

The styles are different, but not as different as most people describe

them to be. The tactics used are different, but the objective is

exactly the same: trying to buy something for less than what

its really worth. Both strategies rely on Grahams famous

Great Quotes

Just practice diligently

and you will do very well.

Johann Sebastian Bach,

arguably the greatest

musical composer of all

time.

Get Posts Free via Email

Email Address

Subscribe

Follow

Recent Posts

Importance of ROIC Part

1: Compounders and

Cheap Stocks

Some Thoughts on the

Berkshire Hathaway

Annual Meeting

Summary Thoughts on

Investment Approach

Great Investor Glenn

Thoughts On Return On Capital And Greenblatts Magic Formula

Part 2

An Exercise on Thinking Differently and a Great Business

Search

About Investment Philosophy Superinvestors

Learning Disclaimer



margin of safety concept, which is probably the most important

concept in the investing discipline.

Both Quality and Valuation Impact Margin of

Safety

The margin of safety can be derived from the gap between price and

value, and it can also be derived from the quality of the

business. The latter point is really part of the former For

example, a business that can steadily grow intrinsic value at a rate of

say 12% annually is worth much more than a business that is

growing its value at say 4% annuallyall other things being equal.

And since the higher quality compounder is worth more than the

lower quality business, the quality compounder offers a larger

margin of safety.

Of course, in the real world, its not that easy. The lower quality

business might offer an extremely attractive discount between

current price and value, which is significant enough to make the

investment opportunity preferable to the compounder. This is often

the case in real lifecompounders are rarely are offered cheaply.

But too often, value investors get enticed by cheap metrics and

seemingly large discounts between price and value in businesses

with shrinking intrinsic value. The problem in these types of cigar

butts is that the margin of safety (gap between purchase price and

value) is largest the day of the investment. Every day thereafter the

business value slowly erodes further, making the investment a race

against time.

Now, not all cheap stocks have eroding intrinsic value. On the

contrary, many high quality, or average quality businesses are

occasionally offered quite cheap. But in my opinion, its always

much more reassuring to be invested in businesses that have

intrinsic values that are growing over time, as it allows for larger

margins of error in the event that youre wrong, and better returns

in the event that youre right. A couple days ago I read a quote

somewhere that I believe Allan Mecham said that Ill paraphrase: If

investors focused on reducing unforced errors as opposed

to hitting the next home run, their returns would

improve dramatically.

Greenberg Discusses His

Investment Philosophy

Markel (MKL): A

Compounding Machine

Categories

Ben Graham

Books

Bruce Berkowitz

Case Studies

Charlie Munger

Education

Enterprising Investor

General Thoughts

Get Better by Reading

How to Improve Results

Ideas-Great

Companies/Compounders

Ideas-Special Situations

Ideas-Undervalued Stocks

Industry -Banks

Industry -Insurance

Intelligent Investor

Investment Data & Info

Investment Fundamentals

Investment Ideas

Investment Philosophy &

Strategy

Investment Principles &

Rules

Investment Process

Investment Quotes

Joel Greenblatt

Martin Whitman

Mohnish Pabrai

Motivational

Overall Stock Market

Portfolio Management

Saber Capital

Management

Shareholder Letters &

Reports



So its like the amateur tennis champion that wins because they had

the fewest mistakes, not necessarily the most forehand winners.

Reducing Unforced Errors and Buffetts 1987

Roster

One way to reduce unforced errors in investing is to carefully

choose the businesses that you decide to own. The gap between

price and value will ultimately determine your returns, but picking

the right business is one important step in reducing errors.

One way to reduce errors is to focus on studying high quality

businesses with high returns on capital. In the last post, I mentioned

an article that Buffett referenced in the 1987 Berkshire shareholder

letter. In this letter, Buffett mentions that Berkshires seven largest

non-financial subsidiary companies made $180 million of operating

earnings and $100 million after tax earnings. But, he says by

itself, this figure says nothing about economic

performance. To evaluate that, we must know how much

total capital debt and equity was needed to produce

these earnings.

So Buffett was interested in return on invested capital. However, he

goes on to state that these seven business units used virtually no

debt, incurring just $2 million of total combined interest charges in

1987, so virtually all capital employed to produce those earnings

was equity capital. And these 7 businesses had a combined equity of

only $175 million.

So Berkshire had seven businesses that combined to

produce the following numbers:

$178 million pretax earnings

$100 million after tax earnings

$175 equity capital

57% ROE

102% Pretax ROE

So Buffetts top 7 non-financial businesses produced fabulously high

returns on equity with very little use of debt. In short, they were

outstanding businesses. Buffett proudly goes on to say that Youll

seldom see such a percentage anywhere, let alone at

large, diversified companies with nominal leverage. Of

Superinvestors

Think Differently

Walter Schloss

Warren Buffett

Blogroll

Above Average Odds

Investing

Aleph Blog

Alpha Vulture

Brookly n Investor

CS Investing

Gannon on Investing

Graham and Doddsv ille

Greenbackd

Greg Speicher

Oddball Stocks

OTC Adventures

Portfolio Management Jar

Reminiscences of a Stock

Blogger

Turnkey Analy st

Whopper Investments

Sites for Investing Ideas andResearch

Guru Focus

Insider Monkey

Market Folly

Seeking Alpha

Value Investor Insight

Value Investors Club

Value Walk

Archives

May 2014 (2)

April 2014 (3)

March 2014 (4)

February 2014 (4)

January 2014 (6)

December 2013 (5)



course, investor returns depend on price paid in relation to value

received, and we are only discussing the value received part of the

equation here.

Buffett then voices his opinion on the importance of predictability

and stability in business models:

He then references an interesting study by Fortune that backs up his

empirical observation. In this study, Fortune looked at 1000 of the

largest stocks in the US. Here are some interesting facts:

Only 6 of the 1000 companies averaged over 30% ROE over the

previous decade (1977-1986)

Only 25 of the 1000 companies averaged over 20% ROE and

had no single year lower than 15% ROE

These 25 business superstars were also stock market

superstars as 24 out of 25 outperformed the S&P 500 during

the 1977-1986 period.

The last statistic is remarkable. Even in the really high

performing value baskets such as low P/B or low P/E groups, youll

typically see a ratio of around one-half to two-thirds of the stocks

that outperform the market. Sometimes youll even have a majority

of underperformers that are paid for by a few large winners in these

basket situations. But in this case, even with a small sample space,

its pretty telling that 96% of the group outperformed over a period

of meaningful length (10 years).

Of course, this begs a question along the following lines: Great, by

looking in the rear view mirror, its easy to determine great

businesses how do we know what the next 10 years will look like?.

Buffett again provides some ideas:

November 2013 (6)

October 2013 (6)

September 2013 (6)

August 2013 (6)

July 2013 (4)

June 2013 (10)

May 2013 (11)

April 2013 (21)

March 2013 (12)

February 2013 (17 )

January 2013 (5)

December 2012 (12)

November 2012 (2)



The idea is to locate quality businesses in an effort to reduce

unforced errors. Again, one way to do this is to focus on valuation

alone. I think Schloss implemented this method the best. Another

way is to study compounders and be disciplined to only invest when

the valuation aligns with your hurdle rate.

And in terms of percentages, there will likely be fewer errors made

(fewer permanent capital losses) in the compounder category than

there will be in the cigar butt category. It doesnt mean one will do

better than the other, as higher winning percentage doesnt

necessarily mean higher returns. But if you want to reduce

unforced errors (reduce losing investments), it helps to

get familiar with stable, predictable businesses with long

histories of producing above average returns on invested

capital.

So circling back to the compounders and the question of: Yeah

the last 10 years are great, but how do we find the winners for the

next 10 years? One possible place to look would be to glance at the

same list that Fortune put together. I attempted to recreat the

Fortune list in Morningstar based on the last 10 years (2004-2013).

As Ive mentioned before, I keep a few quality lists at Morningstar

including:

Non-financial stocks that have grown revenues and

maintained positive earnings for 10 consecutive years

(81 stocks, less than 1% of the database)

Non-financial stocks that have produced positive free cash

flow in each of the last 10 years (596 stocks, 6% of the

database)

Stocks that have produced returns on equity of 15% or

more in each of the last 10 years (143 stocks, or just over

1% of the database)



My attempt to recreate Fortunes list will fall short, because I cant

easily determine the average ROE of these 143 businesses, but this

list would be a good place to start looking. Many of these stocks

have performed very well in the past 10 years, just from glancing at

the list.

And its worth noting that this list is the previous 10 years, it doesnt

mean that these stocks will maintain their strong returns on equity

over the next 10, although research shows that most strong

businesses tend to remain strong over time (mean reversion plays

much less a role than is commonly assumed).

So it might be worth checking out this list, and keeping it as a

watchlist for quality companies that might become available at low

prices at some time or another. Or use it as a list to go through one

by one, learning about successful business models in the process.

Here is a look at the list of consistent ROE stocks sorted

by lowest 25 P/E ratios:

Here is a look at the same list of 143 stocks that have produced 15%

ROE in each of the past 10 years, this time sorted by highest Returns

on Assets:



SHA RE

Remember, all of these firms have achieved at least 15% ROE in

each of the past 10 years, something 99% of public companies failed

to do. This list certainly contains stocks that arent undervalued

(many are quite expensive), but its probably a good list to keep an

eye on from time to time, as it certainly contains a healthy amount

of businesses with compounding intrinsic values.

T AGGED WIT H Berkshire Shareholder Letters Inv estment

Philosophy Returns on Capital ROE ROIC Warren Buffett

1 Tweet 19

18 Responses to 1987 Berkshire Letter

and Buffetts Thoughts on High ROE

Undertherockstocks says:February 20, 2014 at 10:23 pm

1Like



John nice follow-up thoughts. It is rare to find

a high ROIC company at a cheap price,

especially today. But when both factors align, it

is the fat pitch Buffett writes that one needs to

be ready to hit. Until the high ROIC, cheap

price companies in ones circle of competence

appear, what do you tend to do? Look for

special situations, or low ROIC companies at

less than asset value? Or do nothing and wait?

John Huber says:February 21, 2014 at 11:29 am

Undertherocktocks, my

investment philosophy basically

could be generalized as first

looking for high quality operating

businesses with simple,

predictable business models that

produce high returns on capital at

10 times earnings. I secondarily

look for other ideas, which I would

refer to as special situations. I

used to categorize this broad

category more specifically, but I

think it creates too much

confusion when I discuss it on the

site. The basic idea with this

other category is that Im still

looking for gaps between price and

value here Im looking at

corporate events such as spinoffs,

rights offerings, recaps, or just

plain undervalued or hidden

assets. These tend to be shorter

term investments that get sold at

fair value. The compounders are

my favorite investments as the

best ones continue to compound

value for long periods of time.

Reply



mmel says:February 21, 2014 at 9:20 am

I have been thinking about ROE and valuation

more seriously for the last couple of weeks as

well, mainly stemming from re-reading Buffetts

article How Inflation Swindles The Equity

Investor.

I did a screen on Morningstar for companies

that increased their OpMargin every year for

the last decade, only 8 companies showed up.

This led me to looking at Church & Dwight Co.

Despite its apparent high valuation for a long

time, its fundamentals continue improving and

its stock has dominated the SP500.

Another interesting name on the list is Shoprite

Holdings, the South African firm (not the store

in New Jersey). Seems to have some very

strong fundamentals and has been

deleveraging, but its stock ha been hammered

as a result of the emerging market concerns.

mmel says:February 21, 2014 at 9:24 am

As a follow-up, I also posted an

article on SA yesterday that tries

to come up with an intrinsic value

for BRK by comparing the firms

potential ROE to the S&P500.

Perhaps take a look, if you are

interested. I think it aligns with the

idea of determining intrinsic value

and stock return using ROE/ROIC.

Reply

Reply



http://seekingalpha.com/article/2037163-

an-alternative-approach-to-

calculating-berkshire-hathaways-

intrinsic-value


Thanks for the comments

mmel. Ill take a look at your

piece. Thanks for reading.

Pedro Carone says:February 21, 2014 at 11:09 am

@Undertherockstocks:

I like this Munger quote:

It takes character to sit there with all that cash

and do nothing. I didnt get to where I am by

going after mediocre opportunities.

lei says:February 22, 2014 at 6:34 am

excellent article! but i think i am different with

you,john. looking for great business is not an

easy task for me and these stocks often have

high valuation. so i am a deep value investor.


Reply

Reply

Reply

Reply



Thanks Lei. Yeah there are lots of

nuances within the value investing

discipline. I too like deeply

discounted cheap or hidden assets,

but yes, my favorite situation is a

high quality compounder that will

continue to produce significant

value over long periods of time.

But Ilike youam not

comfortable extrapolating todays

results too far into the future, thus

the reason Im not willing to pay

high multiples for what I consider

to be a great business (even though

truly great businesses with long

term futures are undervalued even

at very high multiples). Its

difficult to predict what will

happen to businesses, so it helps to

pay low prices, as that increases

your margin of safety and

mitigates qualitative analysis

mistakes.

Outside of finding quality

compounders at low prices to

normal earnings, I do look at

plenty of deep value stuff,

although as Ive said in the past

couple articles, it helps not to put

each idea into a style box. Were

just looking for simple businesses

or simple ideas that have an

obvious and understandable gap

between price and value.

Sometimes they are cheap stocks

that are left for dead, other times

its possible to locate quality

companies with excellent returns

on capital at a price that gives you

a high earnings yield now, which

means you dont have to pay much

for the excellent economics and

bright future. Either way, both



styles can work well.

jalo says:February 24, 2014 at 6:26 am

I understand your approach with investing in

compounders very easily.

Can you explain the other investment

category? Theres special situations (spinoffs,

restructurings, net nets, bankruptcy, sum of the

parts in other words huge gaps in value) Are

there any other areas where you look for big

gaps of value other then your search for a

strong compounder?

Im personally looking for a portfolio that will

thrive in any economic environment since Im

quite bearish on the economy going forward.

Companies like Coca Cola, Pepsi, Nestle,

General Electric, and Kellogg come to mind.

What I dont understand is the other

component. Can you explain the looking for

significant gap of value. So you look for huge

undervalued situations. Maybe they have a

bunch of valuable real estate.. likelihood of

good capital allocation from a poor business, or

a net net with catalyst?

Its so broad Do you focus on any particular

thing?

John Huber says:February 25, 2014 at 5:55 pm

Hi Jalo,

Reply

Reply



Good question, and it might take

more explanation. But some short

thoughts I dont really look for

one category over the other. And I

dont get into the office thinking

okay lets look at special

situations today or anything like

that. After looking at my

investments in hindsight, these are

the two broad categories that I

could place them in for better

explanation but I really dont

compartmentalize the research

process. Im just turning over

rocks, spending a lot of time

reading, and researching new

ideas. Sometimes they are great

businesses with great economics,

other times they are plain cheap

stocks with some sort of

recognizable significant gap

between price and the value to a

private owner. I would group these

cheap assets with other special

situations simply because they

tend to be shorter term

investments by nature. Sometimes

a cheap stock appreciates and gets

sold in a year or two, whereas

great compounders ideally stay in

the portfolio for longer periods of

time as they continually

compound value for owners.

But in both situations, Im thinking

much more about the entry price

and value, and rarely do I think

about exiting. Im comfortable

owning stocks for long periods of

time. Its just that special

situations/asset plays tend to

resolve themselves at some point,

and if they arent compounding

value at high rates, the



opportunity cost of holding them

increases over time as they

appreciate, so they tend to get sold

at fair value.

Regarding the significant gap

question yes, Im just looking for

very large gaps. I am very patient,

and very choosy when it comes to

investments. My feeling is that too

many investors fill their portfolios

with mediocre ideas and modestly

undervalued ideas, which means

that those ideas have much lower

margins of safety. They do this in

the name of diversification, but I

believe that it negatively impacts

both safety and future returns.

With net-nets, it might be different

as its more of an insurance bet.

But on a case by case situation,

you need to identify the most

obvious, most significantly

undervalued situations in order to

achieve large margins of safety

and large future returns. As Pabrai

says, Im not interested in a stock

that trades at 10 thats worth 14,

or 16, or even 19. He wants a

minimum 50% discount. Ideally,

were looking for these types of

gaps. There is an art to valuing

compounders, but I try to create

conservative ideas for what the

business will be doing in normal

times at various points, and I

decide what those normalized

earnings are worth to me. The

benefits to investing in quality

compounders is that they are very

forgiving. You can be wrong about

the value estimate, but as long as

the business is growing value, your



risk of permanent loss is mitigated.

And the other major difference

between a compounder and a net-

net or other stock with static (or

eroding) intrinsic worth is that

with the compounder, the values

are a moving target. They are

increasing each year, thus

increasing your margin of safety in

the event of a stagnant stock price.

This is a very pleasant situation

when you can find it.

Also, I rarely am bullish or

bearish on the economy. You

may have a view, and many who

are smarter than me might be able

to act on a view, although its very

tough to do for even the smartest

economists. The companies you

mentioned are outstanding mature

companies, although they are in a

stage of life where their intrinsic

value is growing at unnexciting

returns (probably 6-8% or so). My

off the cuff opinion of most of the

large quality firms like that is that

your investment returns will equal

those rates of value increases over

time, and shareholders shouldnt

expect much more unless they can

acquire those firms at significant

discounts but the firms you

mentioned are certainly fortresses

that will likely be quite safe over

time.

Jonathan says:February 24, 2014 at 3:51 pm

Reply



well John, I guess I am a chain smoker I cant

seem to give up my cigar butts! granted owning

compounders, is a more ideal situation but a

basket of cigar butts ( 10 or so) is just so

appealing. even this past decade net nets

trading 75% or more below NCAV beat the

market by 5-10% ill have to check the numbers

once I get home for exact quotes.

like you I like cheap and good, but I also like

extremely cheap. sometimes cheapness is the

catalysis.

great post as always my friend.

John Huber says:February 25, 2014 at 1:10 pm

Thanks Jonathan. Yeah the cheap

stocks are always interesting. And

again, Ive talked a lot about

quality lately, but were really just

trying to find the largest gaps we

can between price and value. And

it has to be understandable. The

cheap stocks are often the simplest

and the most quantifiable, thus

their attractiveness. I agree with

that, and like Graham and Schloss

taught us, it is a perfectly viable

strategy.

Tuna says:February 28, 2014 at 8:59 pm

Hey John,

Reply

Reply



Another amazing article! Always love reading

the comments too as there are a lot of gems in

there.

I get the feeling you coattail other successful

investors. For those investors that run a fund

above $100MM, how do you track freely what

they bought/sold? I noticed Gurufocus.com

does this for free on a delayed basis. But they

do have a $300/year where its revealed on real

time (90 day delayed still). Any resources

would be helpful!

John Huber says:March 2, 2014 at 11:22 am

Thanks for the comment. Yeah I

like looking at what other

investors are doing, as I get

numerous ideas from them. I

wouldnt say I coattail though I

mainly use the 13-fs as idea

generators, and then do my own

research on ideas that appear to be

valuable.

I really just use the SEC site to

research the holdings. Its free,

and its easy to use. Alternatively,

you can look at sites like Whale

Wisdom, that aggregate the data

for you to make it easy to view. I

use that site, and also use

GuruFocus, which also does an

excellent job at summarizing the

buying and selling of these

gurus.

I dont spend much time trying to

figure out whos buying and selling

what, though. I really just spend a

few minutes each quarter going

Reply



over the portfolios of a few value

investors I respect, and

occasionally I get something

interesting.

Mohammed Al-Alwan says:March 4, 2014 at 6:32 am

I think high RoE metric is a good starting point

but totally irrelevant for future investment as

its backward looking. Theoretically as long as

RoE >Cost of equity the main value driver is

future growth. So, if you a have a business with

100% RoE but with no future growth

opportunities its franchise value is zero

regardless of how high is the RoE .While some

times a lower RoE business with say 15% RoE

has big reinvestment growth opportunities and

as result will have a much higher franchise

value. This explains buffet focus on durability

and consistency (CAP period)+Reinvestment

opportunities. Because their relationship is

multiplicative you need both factors in play.

The problem is that future investment

opportunities wont appear in the company

financial statements as buffet said before our

best performing investments were made when

the number did not support it. What I think

buffet meant was that future growth

opportunities for these companies are high and

as result they have the ability to reinvest at high

RoE for many years to come justify the

purchase price that did not look cheap at that

time. The challenge is that these future growth

opportunities cannot be easily assessed

quantitatively and needs deep industry

knowledge, common sense, and deep

understanding of the magic of compounding.

Reply

Reply



John Huber says:March 4, 2014 at 11:54 am

Thanks for the comment the

simplest way to think about this is

that a firms future ability to grow

its value intrinsically is simply the

product of two factors: the

incremental ROIC and the

reinvestment rate (how much can

it retain from earnings to reinvest

at that same ROIC). So a business

that produces 20% incremental

returns on capital that can reinvest

50% of its earnings at that rate will

grow intrinsic value at a rate of

10% annually (50% times 20%).

Likewise, a firm that produces

10% ROIC that can reinvest 100%

of earnings will grow at 10%

annually (100% x 10%). A

business that makes 50% ROIC

that can only reinvest 30% will

grow at 15% annually, etc Also,

the firms with lower reinvestment

rates but higher ROIC will likely

create more value for

shareholders (assuming the same

intrinsic value growth rate)

because it still has a large portion

of its earnings to either buyback

stock or make accretive

acquisitions (or just pay

dividends). Of course, they could

destroy value as well

Mohammed Al Alwan

says:March 4, 2014 at 1:21 pm

Reply



Thanks for your comment

I think there is some

confusion on terminologies

here. Reinvestment

opportunities is not the same

as reinvestment rate.Many

companies go for high

reinvestment rate but few

reinvestment opportunities

and as result end up

destroying value.

John Huber says:March 4, 2014 at 1:43 pm

Correct as I say, a

business compounding

rate is a simple formula.

Its the product of its

reinvestment rate (the

amount of capital it

reinvests each year)

multiplied by the return

it achieves on that

capital (ROIC). A

business intrinsic value

will grow (or shrink) as a

direct result of those two

factors. As you correctly

point out, if it reinvests

money at low returns it

will grow value at low

levels (likely not

exceeding its cost of

capital, which will

destroy value). Also, if a

business doesnt have

reinvestment

opportunities (0%

reinvestment), it will not

grow. In either case,

Reply



capital allocation is a

third component to the

overall company value,

as management can still

grow value per share by

prudent capital

allocation.

To simplify it, I wouldnt

differentiate between

reinvestment

opportunities and

reinvestment rate. If a

business reinvests 100%

of its earnings then the

reinvestment rate is

100%. As you say,

maybe they destroy

value by only achieving

4% returns on that

investment. I think what

youre saying is that

maybe management

doesnt have much

opportunity to reinvest

at high ROICs, and thats

often true.

But the math is simple:

the business will invest a

certain amount of its

earnings, and that is the

reinvestment rate. That

investment will produce

a certain return, which is

the incremental ROIC.

The enterprise will

compound at a rate that

is the product of those

two factors. And outside

of the enterprise itself,

the excess cash (earnings

that cant be reinvested

into the business) can



also create or destroy

value.

Leave a Reply

Your email address will not be published. Required fields are

marked *

Name *

Email *

Website

Comment

You may use these HTML tags and attributes:

Post Comment

Notify me of follow-up comments by email.

Notify me of new posts by email.

Reply

About Investment Philosophy Superinvestors Learning Disclaimer

Documents

1987 Berkshire Letter and Buffett's Thoughts on High ROE _ Base Hit Investing