Charlie Munger, Vice Chairman of Berkshire Hathaway, and inspiration for many investors in quality companies, put it like this in his speech in 1995:
“Over the long term it is hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, you are not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns an 18% return on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.”
Our intention here is not to argue with that statement – it is factually correct – but to examine its real-world application.
Yes, businesses earning a high return will result in better outcomes than businesses earning a low return even if the investor pays a high price for the good business. Figure 6 shows the numbers over a 40-year holding period.
Arithmetically, the numbers add up. Even with a big change in the ending valuation, the high-quality stock still outperforms by a wide margin. So much for the theory. What about the practice?
Time matters. Finding a company that can actually re-invest at 20% a year for such a long period seems close to impossible.
Take a hypothetical firm in today’s FTSE 100 index of UK stocks. If it starts with a book value of £10 billion today, and returns 20% per annum for 40 years, the company would be worth £14.7 trillion in 2060. On rough maths, that would be around 10% of the entire world’s forecast GDP. Even if a large company could grow at such a high rate for so long, it is highly likely to hit regulatory restrictions and competition issues, which would dent profitability.
If we assume that a company’s return on equity drops from 20% to 10% after five years due to emerging competition or dwindling re-investment opportunities then an investor needs to pay 25% less on day one to achieve the same total return.
What’s more, few investors have a 40-year holding period in practice. The long run is a theoretical construct; each investor only has one run.
An assumed holding period of 20 to 40 years clearly diminishes the importance of starting valuations when buying a stock. Yet the longer the holding period, the more an investor is exposed to the unpredictable and potentially damaging effects of time.
Rapid technological change means the average lifespan of a company in the S&P 500 index is now less than 20 years and falling, from an average of 30 years in the 1960s (Figure 7).
In Figure 8, we use a more realistic time frame of seven years. The returns change dramatically. Over a seven-year period, the investment in the lower-quality company delivers better performance. This is because, for the high-quality company, the impact of the fall in its valuation (de-rating) dwarfs the superior compounding of its higher return on equity. Even if the lower-quality company de-rated by 10%, the returns between the stocks would be equivalent.
Our key point here is that valuation – the price you pay – is as important as business quality. This is a point we think demands more attention.
Coca-Cola provides a good example. It is undoubtedly one of the world’s greatest brands and businesses. Say you bought the shares in 1998, when the stock traded on 50x earnings, or a 2% earnings yield. The share price fully reflected a lot of future growth. From 1998 the stock fell over 40%, and even including dividends it would have taken until 2010 for you to make money from your investment. Fast forward to 2019. After two decades as a Coca-Cola shareholder, your total return, including dividends, is only 3% a year, far less than the equivalent 7% return from the (qualitatively inferior) broad stock market and that is before inflation is considered.
Fig 6 Valuation and returns with a 40-year holding period
|
Return on equity % |
Starting valuation |
Ending valuation |
Compound annual return % |
High-quality company |
20 |
4x price/book |
2x price/book |
18 |
Low-quality company |
10 |
2x price/book |
2x price/book |
10 |
Fig 7
Fig 8 valuation and returns with a seven-year holding period
|
Return on equity % |
Starting valuation |
Ending valuation |
Compound annual return % |
High-quality company |
20 |
4x price/book |
2x price/book |
9 |
Low-quality company |
10 |
2x price/book |
2x price/book |
10 |