How to identify great companies to invest in – Part l

Owner earnings

A rock solid foundation

We only invest in superb companies, and then only at very attractive prices. An investor will identify very few companies that meet all their requirements to be thought of as a superb company.

To identify superb companies, I think you have to look at four key features. I put them in the order in which investors might think about them. If the company doesn’t have the first feature, with certain very limited exceptions, there is no point going further. The first feature is the ability of the company to generate Owner Earnings . The second is the company’s business franchise. The third is management. The forth is the superiority of business operations. Naturally there are more factors, as discussed in the Motherlode, but these are the main ones. To look at all the factors take a look at Chapter 31. General approach to choosing common stocks.

The basic idea of Owner Earnings is that superb businesses generate far more cash than they can use internally. This is Owner Earnings . The value of Owner Earnings to shareholders depends on how effectively this cash is deployed by management – capital allocation.

The concept of Owner Earnings is Warren Buffett’s invention. In his 1986 Chairman’s letter to the shareholders of Berkshire Hathaway, Buffett included a lengthy discussion of the purchase-price adjustments made on the balance sheet of a business they had acquired as a result of paying a premium of $142 million over book value!! The adjustments Buffett made resulted in changes to the balance sheet and also the income statement. Buffett pondered the question as to what all this meant to the shareholders.

Buffett writes:

“If we think through these questions, we can gain some insights about what may be called “owner earnings”, These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since(c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”” (Emphasis added)

{{ I note as an aside that this quote from Keynes is one of the most profound observations in investing. The world is inherently uncertain. Sadly for the positivists and quants of this world there are many important things that cannot be counted precisely.}}

Rather than deducting what the company happened to spend in one year or even average five years capital spending, Buffett makes an assessment as to the capital spending necessary to maintain the company’s competitive position. This may leave substantially less free cash than typical calculations of Free Cash Flow produce.

It is Owner Earnings that Buffett uses to judge the performance of the company and its management. It is also Owner Earnings that Buffett uses to assess the intrinsic value of a company.

Once Buffett has made his ‘vaguely right’ estimate of Owner Earnings, he then asks himself whether the company can make good use of this surplus cash. He says: “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.” (Buffett W. E., 1998)p.86.

In short, Buffett is looking for companies that (a) produce substantial excess cash, and (b) can employ this excess cash at very high rates of return. Both of these qualities tend to be present in companies that produce a great Return on Invested Capital (ROIC). But not necessarily. See my post: Be wary of using Return on Capital (ROC)

One doesn’t have to predict future earnings so much as identify companies that have the Free Cash Flow to invest for future growth. This is the important first step in determining whether this is a business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.

Many investors focus on the statistic of five years of historical growth in revenue and earnings rather than examining the root return on invested capital and Free Cash Flow that lead to that growth. Historic growth tells us almost nothing about the future.

Of course, Free Cash Flow or substantial Owner Earnings merely indicates that the company has the wherewithal to invest for future growth. It doesn’t prove that the future growth will happen.

Per John Neff, we are looking for companies with ‘dominance or major participation in definable growth areas’. That is, we must be mindful of both the financial ability of companies to invest for growth and also their opportunities to do so. I will deal with this in a future post. It’s also in the Motherlode. See references below.

It almost goes without saying that companies we want that are generating substantial Owner Earnings must also tend to have rock solid balance sheets. We dig into this Chapter 35. Capital Structure, Strength and Economic Performance

The next post in this series is How to identify great companies to invest in – Part ll

The post following that is How to identify great companies to invest in – Part lll

For readers wanting to dig deeper into this subject, take a look at Part 6: The Hallmarks of Superb Businesses

In particular, see Chapter 31. General approach to choosing common stocks

And specifically, Sections:

31.19 The business franchise – the Moat,

31.20 Management

31.21 Understandable and superior business operations

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

If you like this blog, tell your friends about it

And don’t hesitate to provide comments