“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Shareholder Letter
If someone offers you a choice between either paying 50 cents on the dollar for the assets of a low returning business, or paying face value for the assets of a business that can compound its earnings at high rates over a long period of time, which offer would you take? Think carefully – buying $1 for 50 cents may allow you to double your money, but the low returns mean earning power will remain much the same in 5, 10 or 20 years’ time, or even less if conditions deteriorate quicker than expected. The “compounder” – a business that can reinvest a majority of its earnings at high returns on invested capital (“ROIC”) – will over an extended period create enormous wealth for its owner, regardless of economic or market gyrations in the interim.
Both examples above fall under the umbrella of value investing, but they can clearly lead to a divergence of long term results. Proponents of the former Graham-style deep value investing typically prioritise valuation and “cheapness” over quality. A stock that is cheap enough from a valuation standpoint (e.g. trading at a discount to net tangible book value) can produce an attractive return for investors if it re-rates, irrespective of quality or long term prospects. And while numerous investors through the years have generated enviable returns from these “cigar butts” (including Buffett in his early days), we at Montaka prefer to spend our time searching for high quality businesses that can compound their intrinsic value at high rates of return over a long period of time.
Below are three key reasons why we focus on identifying these high quality, compounding businesses that are priced below their intrinsic value. For an investor, finding and holding on to just a handful of these great businesses over a lifetime can lead to superior investment returns.
- A high quality business with a wide moat that can generate high returns on capital over many years can provide investors with outsized returns, or become the proverbial “10-baggers”. For such a business, intrinsic value is not a static point, but compounds over time at the rate which the company can reinvest its earnings at high returns. More importantly, this compounding effect, when bought at a discount to present intrinsic value, also provides investors with a wider margin of safety. If an investor’s initial assessment of present intrinsic value proves optimistic, a high quality company can still compound its way to an acceptable return over time.
- For an investor with a long term investment horizon, business quality becomes an increasingly important factor of investment returns. For cigar butt investment, time is running against the investor because i) the $1 on offer isn’t necessarily durable; and ii) the longer it takes for the stock to converge on some measure of fair value (e.g. tangible book value), the lower the return will be. As the hypothetical example below shows, a mediocre company earning 6% ROE held for 20 years will generate a mediocre return compared to a high quality company compounding its intrinsic value at 20% ROE, even if it is bought at a significant discount.The above example assumes an investment is made into two companies, one earning 6% ROE and the other 20%, but otherwise identical. The investment in the low return company (Table A) is made at a 50% discount to book value and exited at 1x book value after 20 years. Table B shows that while a short holding period can generate attractive investment returns (mainly driven by the assumption that the stock will re-rate to 1x book value in the meantime), returns diminish as the holding period increases because a business that cannot earn above its cost of capital (or cost of equity in this case) will be destroying shareholder value in the long run. The investment in the high return company (Table C), despite being made and exited at 1x book value, still generates a superior long term return as the business is able to compound its intrinsic value at a rate of return materially higher than its cost of capital.
- As a corollary of the point above, a strategy that focuses on identifying and holding on to compounders should result in less portfolio turnover. This has the benefit of reducing the number of new ideas required to replace existing positions as they are exited, and minimises the negative impact that tax and transaction costs have on investor returns.
Having said the above about quality vs valuation, it would be remiss to not reiterate the vital role that valuation plays in our investment process. Our favourite businesses are the ones that can reinvest large amounts of cash at high returns on capital over extended periods, and also trade below our assessment of present intrinsic value. As Andy explained in a previous blog post, paying an expensive price for a compounder can lead to mediocre returns. However, if an investor sticks to buying compounders at a discount to value, the margin of safety should mitigate their downside, while business quality and the ability to compound intrinsic value at high rates of return can take care of the upside. To emphasise this further, if the investment in Table C above could be made at 30% discount to book value, the return would be an even more attractive 28%. At Montaka, we believe an investment process that adheres to these principles will reward investors very well in the long term.