Again, compound return really is the center point, and ultimately we spend much of our time trying to identify those businesses which are most likely to compound the shareholder’s capital at an above-average rate. Were we simply a pure value investor, we would be regularly looking to unload those securities, which appreciated to some predetermined notion of present value, and we would lose out, in our minds, on the opportunity to compound our capital because of these sales.
One of the acknowledgements I think we’ll all gladly accept to is that high return businesses have something unusual going on which in fact allows them to earn above average rates on unemployed capital. Often these special circumstances are referred to as moats. In our firm is the properly identify what is the nature of the moat; what exactly is it that’s causing this good result. And to us this is a really critical point.Because the investment business can have so many issues that upset the apple cart, being confident about what it is exactly that’s causing the results is a huge advantage for us. In point of fact, we have on occasion been able to add to positions in time of turmoil, because the confidence in understanding a business allowed us to see through all the noise in the marketplace.
Now it’s time to go fishing. The pond I want to fish in is the one where all the fish are the high return variety. Naturally, if my returns are going to correlate to high ROEs, then I want to shop among the high-return, high-ROE businesses. In our firm we use this visual construct to represent the three things that we focus our attention on. This construct in fact is an early 20th century three-legged milking stool and before I go on to describe each leg to you I want you to see that the three legs are actually sturdier than four, and that they present a steady surface on all kinds of uneven ground, which of course, is their purpose in the first place.
Leg number one stands for the business model of the company. And when I say business model, I’m thinking about all the issues that have come into play that contribute to the above average returns on the owner’s capital. Earlier we called this the moat. You know the drill: Is it a patent, is a regulatory item, is it a proprietary business, is it scale, is it low-cost production, or is it lack of competition? There are certainly others but for us, it’s important to try to understand just what it is about the model that causes the good returns. And what’s the outlook? In our office we often say, “How wide and how long is the runway?”
Let me tell you a quick story. About 25 years ago I had an intern working with me and I gave him a box of articles I’d saved relating to businesses which had caught my eye but which I had done no work. And he came back some days later with a piece on a company called Bandad, which was located here in the Midwest in Muskoteen, Iowa, and my intern explained to me that we should look at the business that had 20% ROE, low valuation, growth opportunities and so on, and I said “What business is it in?” And his reply was that it was in the tire business. And so I said that’s interesting, why don’t you go look at all the returns in capital and all tire companies? And he did and he came back and he reported that all those companies had returns on the owner’s capital in single-digits. So here we were with a business which described itself as the largest independent truck-and-bust tire recapper, but our quick return analysis said no way, it can’t possibly be in the tire business.
So our mission therefore was to discover what was the real source of the earnings power for the business, allowing them to have such returns. Well if you went to Musketeen to meet with the CEO, who by the way, greeted us with his feet on the desk eating an apple. I won’t bore you with all of the bizarre history – and it is indeed bizarre – but we concluded that the company’s tie to its independently owned distributers and service centers was at the core of its business value. And those independently owned business men were incredibly loyal to Bandad, especially because of the outstanding way that they’ve been dealt with by Bandad during and after the 1973-74 oil embargo. It turns out that each of these independent business men who typically work from 6 a.m. to 8 p.m., unlike their Goodyear stores who had managers who worked from 8 a.m. to 6 p.m., were enormously grateful for what the company had instituted called the powerfund during the oil embargo. They put this in place to collect all of the excess profits that the company made when the price of oil began to decline, and they made a deal with all of these independent managers that they would return money to them in direct proportion to the sales. You know, they bought the tire tread, which was an oil-based derivative, from Bandad, and used it during the recapping process. So, the independent businessman wasn’t allowed to go buy a new Cadillac, but he could buy a new shop, build a new shop, get new equipment, whatever, all through this power fund that Bandad had put in place. And so this power fund in fact really lost its economic underpinnings and the company ran into difficulty and years later, it was later acquired actually, in 2007 by Bridgestone. We owned the shares for several years and had a very profitable investment, but sold them when we lost confidence in the business model. It was unique, but my point is, simply trying to understand what it is that’s causing the good return, and how long is it likely to last. It was a profitable investment for us, but not a great compounder.
So my point here is simply that the source of a business’ strength may not always be obvious. Therefore, understanding that first leg of the stool, the business model, has its own level of difficulty. It’s also where the fun is, I might add, and we believe it is absolutely critical. As I said, we spend countless hours at our firm working on these issues every week.
The second leg of stool is what we describe, is the Peevol model, and what we are trying to do is to make judgments about the focus around the business. We often ask ourselves, do they treat public shareholders as partners, even though they don’t know them? My good friend Tom Gaynor who you heard from yesterday describes it this way: He said do they have equal parts skill and integrity? What we’re trying to do is get at is this: What happens at the company level also happened at the per-share level. My life experience is, once someone puts his hand in your pocket, he will do so again. And presumably, we’re examining the company in the first place because we already determined that the managers are killers about operating the business. And because we run concentrated portfolios, we literally have no time to mess with those managers about who we have real questions about in our real experience.
Here’s another story: About 30 years ago, I owned a very, very, very, let me emphasize, very tiny interest in a company called Charlotte Motor Speedway, which over the years has come to be called Speedway Motorsports. And the principal shareholder then, and possibly still is, is a person who had a negative history with the SEC. The agency had barred him from having any association with the company for a period of several years. And this was perhaps 35 or 40 years ago. At any rate, this majority shareholder returned to the scene, and by the mid-‘80s had accumulated 70% of the stock of Charlotte Motor Speedway, and he … tendered for all of the minority shares that he didn’t own. When I joined … in Charlotte, North Carolina, which after discovery was successful in getting us a settlement that was several times the proposal going private price. This issue confined the CEO, which in all likelihood caused him to settle with a long list of misbehavior including improper valuation, failure to include corporate assets, a lack of independence of outside opinions, and so on. Quite naturally he demanded that a settlement be sealed and it was. I’ve never since held a position in any of that CEOs public or private companies, because he had indeed put his hand in my pocket.
Following my Charlotte Motor Speedway experience I bored down a new holding in International Speedway (ISCA), and I discovered that it was in fact the best out of the three
public companies involved in NASCAR racing. And my experience in International Speedway was a good example of our approach. When we first invested in ISCA in 1987, the metrics were as follows: The ROE was in the mid 20% range, the income margin was over 50%, book value per share had a CAGR 28%, there was no leverage, it had a modest valuation, it had attractive growth prices, and there was huge, over 50%, insider ownership. We owned shares in International Speedway for a good many years, and had good experience of compounding our capital at generally between 10 and 20 times our cost, depending on when the shares were purchased. We later sold all of our shares when we became concerned with the management’s approach to all aspects of the business. The CEO had died, and other family members were running the show, and in addition we were concerned about the runway for their business, as times were changing. So our sales decision was judgment relating to the second leg of the stool, the management model, as well as our view of the business model itself.
We refer to the third leg of the stool, which quite obviously gives it its stability, as something... as the glue that holds the opportunity together. My next question, therefore, is does an opportunity exist to reinvest all the excess cash generated by a business, allowing it to continue to earn these attractive above average returns? My experience tells me that the reinvestment issue is perhaps the single most important issue facing any CEO today. As in once place where value can be added or subtracted quickly and permanently. So this really relates to both the skill of the manager, as well as the nature of the business. One of my favorite questions to ask a CEO is, “How do you measure the ways in which you are successful in running a business?” And I can tell you that very few ever answer that they measure their success by the growth in economic value per share. Not surprisingly, we hear that the increase in the share price is the answer, rather simply say chief incorporate goals established in conjunction with the board is the answer, and some say that ...accomplishments relating to customers and employees and the community and the shareholders are all the answer. Personally I’m deterred in my view that growth in real economic value per share is the holy grail. Just look at the opening pages of the Berkshire Hathaway annual report, and what do you see? You see a record of growth in book value per share, for 40 years. Forty years. Incidentally, in Berkshire that number, you know, is 20% a year for 40 years, and so it’s no wonder that Warren shows up here as the top of the Fortune 400 list.
After we’ve identified a business that seems to pass the test in all three legs we refer it as our compounding machine. And as we describe it, our valuation discipline comes into play here and we describe it here as simply we are not willing to pay too much.
There’s an old Wall Street ad agent attributed to Goldman Sachs...which says, “Something well bought is half-sold.” Taking a completely different tact, if we had properly identified the compounding in machines and had bought them at modest valuations, we would be set up for the famous Davis double play. That is, the business... will compound our capital at an above-average rate, and we’re in line for an increase in market valuation, but double play indeed.
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