Could you begin by telling us how you got into investing?
I kept moving in the direction of things that interested me and ended up getting involved in the stock market after I finished school. I became a stockbroker and did that for 21 years. I morphed over into the research end of the business and started putting those research ideas into an investment management firm at the brokerage in Washington in 1985-86. I started my own firm in 1989.
How has your thought process evolved?
The evolution of thought process started way back when I was a broker. I was puzzled by the question of what makes a good investment and what makes a good investor. I started analysing the rate of returns of all kinds of asset classes.
I looked at the rate of return for common stocks for the preceding 60 years of recorded history. It stood at 10 per cent. I said to myself: what's important about 10 per cent? What I concluded was that it was at that rate because it was related to the real rate of return earned by all of these businesses on their owners' capital — what we call RoE today. And it caused me to posit this notion that my return on an asset will approximate the RoE over a period of years, given constant valuations and the absence of any distribution of profits.
Do a back of the envelope calculation. Take a $10 stock with a $5 book and $1 worth of earnings. The RoE is 20 per cent. Distributing none of the earnings and keeping the valuations constant you get 10 times earnings and two times book. Grow the earnings by 20 per cent and we find the earnings become $1.20, the RoE is still 20 per cent, and the price at 10 times earnings goes to $12. Therefore, the return on the asset approximates the RoE.
The second piece is: how do you measure when an investment is successful? If I throw that question at you, you would say, “If the price goes up!” Well okay, now suppose it is a private company and you do not have the opportunity for price discovery, then how do you tell?
Well, if they pay me a dividend! But suppose the company does not pay any dividend?
The answer is that at the end of the year you either look into your lockbox or you ask your accountant and he tells you that the shareholders' capital went up by X amount.
Therefore, the way you tell whether an investment is successful is by growth in the real economic value per unit of ownership. We often use the visual construct of a three-legged stool to help us think about that. Leg one has to do with the business model — identifying these high-return businesses. Leg two is what we call the people model — identifying managers who view the public shareholders as partners. Leg three has to do with the re-investment model — the skill of the manager and the nature of the business; whether there is an opportunity to re-invest all the excess capital generated in ways that will help it to continue earning high rates of return. When we find companies that have all the three, we call them our compounding machines. And then, we don't want to pay too much for them.
How do you go about looking for companies with moats?
That is a critical question. I grew up in the Washington area. A man by the name of Eugene Meyer bought the Washington Post (WP) in 1934 off the steps of the courthouse in a bankruptcy sale. For the next 65-70 years, WP was a great business with a great franchise and a moat that got better. When the Evening Star closed down in 1981 they were the only game in town.
However, about 10 years back or so, circulation at the WP and all the other major dailies of this country started declining, but at a very modest rate of 1-2 per cent per year. WP could overcome the impact of that with its pricing — its moat. We could see a little erosion around the edges of the franchise in circulation but that was not particularly worrisome. Then about five years ago, the business model just fell off the cliff — for WP and for every other major newspaper because the internet had struck at their principal revenue driver — advertising. The Internet made it faster, cheaper, and more focussed for advertisers than print advertising. Therefore, here is an economic moat that prospered for nearly 70 years and then just disappeared overnight. It is a very interesting lesson and we see it in a lot of places.
I was reading a piece yesterday where the author was reading a speech given by Charlie Munger to a bunch of students. It was about Coca Cola and Munger never even once in his description talked about balance sheet or income statement or cash flow or anything like that. He talked about market shares, brand name, and all of those issues. So whenever we are looking for businesses, we try to understand the nature of the moat and the economic conditions that cause the business to earn above-average rates of return.
Do you have a benchmark for the minimum return on capital you expect?
Years ago, I used to keep the threshold limit at 20 per cent in terms of RoE. Today I would say it is generally in the mid-teens. However, what we are really looking at is free cash flow return on owners' capital and then try to make adjustments for if they are buying back stock above book, etc. What we are trying to understand is: what is the nature of the economic opportunity and is it getting better or worse?
Nevertheless, you have invested in companies with even lower RoEs.
Yes, I will explain with an example. We have owned a company called Markel Corporation for 20 years now. It is a speciality property casualty insurer. For the majority of that time, say 15 years, it grew book value per share at around 20 per cent. However, in the last five years it has been growing at about half that rate. We continue to hold it for a couple of reasons.
One, we are probably in our sixth or seventh year of weak pricing environment in the property casualty business. My experience is that it will turn one of these days. And when it does, it will have a powerful effect on the economics of a company like Markel.
Two, the people who run Markel think about the business as owners and have a history of treating public shareholders in a fair and equal way. Many years ago, for instance, they eliminated their options programme and instead offered the employees a programme to buy the shares at a discount. They found it made more economic sense for the public shareholders.
Three, the reinvestment part of the business. In the last couple of years, Markel has embarked on a model that is similar to Berkshire in that they are quite active in buying 80 per cent or even 100 per cent of businesses that have nothing to do with insurance. They are building an economic engine inside the corporation away from their insurance business, like Berkshire has done. So we think the opportunity exists for them to compound the book value at a rate that is in the upper teens or higher and we expect to see it in the next couple of years. That's why we haven't sold it — great people, great history with great opportunities, but going through a bit tough period.
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