The three legs of our investment stool represent the essential ingredients for a business to compound: an extraordinary business model, exceptional people, and abundant reinvestment opportunities. Elsewhere, my partners address the importance of a strong business model and exceptional people. My topic is reinvestment.
The people running a successful business are regularly faced with the decision: what to do with the cash earnings? At the most basic level, there are two possibilities. First, they can retain the cash and invest it with the aim of increasing the value of the business. This is what we call reinvestment. Second, they can pay out some or all of the cash to shareholders as a dividend.
Right away, we can begin to understand why reinvestment is so critical. The ability to earn earnings upon earnings is essentially the definition of compounding. In the long run, we feel strongly that the rate at which the value of a business compounds will approximate its returns on reinvestment.
With an outstanding reinvestor at the helm, even an ordinary business can become a remarkable compounding machine. There are abundant examples, including of course Berkshire Hathaway, which began its compounding journey as a struggling textile mill.
And yet, we so often observe dividends being prioritized by investors and pundits. The reality is that dividends are the route to average returns, and our goal is decidedly to seek above-average returns. Excellence in reinvestment is the route to such returns.
This is simply because markets recognize and put a high price on businesses with high returns on invested capital. The price a shareholder pays for a wonderful business is typically a substantial multiple of the actual capital invested in that business. And, unfortunately for the dividend-centric investor, it is this ratio of market price to invested capital that dictates the returns available to shareholders on any earnings paid out as dividends.
To illustrate: If a business has an underlying 21% return on capital, but an investor paid a market price of 3x capital to acquire the stock, then a 100% dividend of all earnings would only yield the investor a 7% pre-tax return (the arithmetic: 21%/3 = 7%). This is very much an average return, even though the underlying business has excellent returns on capital. While the underlying business model may be outstanding, and while the business may be run by exceptional people, the lack of reinvestment opportunity and a decision to payout 100% of earnings will cause shareholder returns to be just average.
On the other hand, if it were possible that all earnings could be retained and reinvested at the same 21% rate, the shareholder would receive no dividend, but the capital and earnings of the business would both grow at the rate of 21% per annum. Over the long term, if the stock is purchased at a reasonable multiple, its market price would grow more or less in parallel with the rate of growth in capital and earnings. The shareholder, in this example, would build capital gains at a rate in the neighborhood of the underlying 21% growth rate, for so long as the runway of excellent reinvestment opportunities persisted. To top it off, the shareholder would enjoy tax deferral on the gains. If you know of any businesses that can retain 100% of earnings and reinvest them at a 21% rate, please give us a call!
Within our portfolios, different businesses we own have different strategies for reinvestment. Some are expert at acquisitions, and others rely primarily on organic reinvestment such as the purchase of fixed assets and inventory that may be required to expand sales and earnings. Some, such as Markel, have a reinvestment strategy that enables them to be opportunistic across a variety of asset classes and industries. The people at Markel constantly assess where the best opportunities lie to reinvest capital and grow book value per share. As written in their 2013 shareholder letter: “…each day, we get to choose from a varied menu as to how to allocate capital to continue to build the value of your company.” Their varied menu includes capital to support insurance underwriting, the purchase of public equities, the purchase of private equities, acquisitions, and share buybacks. In the past five years, Markel has grown book value per share at a rate of 17% per annum. While not every five year period can be so robust, regular appreciation of book value per share in the teens is certainly plausible. And Markel, like Berkshire, has never paid a dividend.
With exceptional results like these on reinvested capital, why would we want to receive a dividend? Alongside a strong business model and exceptional people, abundant reinvestment opportunities are the key to high rates of compounding returns.