Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 380

Buffett and his warning about 'virtually certain' earnings

When Warren Buffett was asked to distill the essence of investing success, he offered the following:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

Quality is low debt and high rates of return

I am wedded to a relatively strict idea about what a quality business is. A company should sustainably produce high returns on equity with little or no debt. Why? Because it suggests the company has a competitive advantage.

You see, when companies generate high rates of return, they attract competition. The easiest and most mindless way for new entrants to compete is to offer cheaper prices, which of course reduces gross margins, putting pressure on net margins and therefore returns on equity. If a company can generate a high rate of return on equity sustainably it has been able to fend of the competitors or sufficient barriers to entry exist to block or slow their entrance in the first place.

A high level of debt relative to equity can artificially boost the returns on equity but of course debt carries risk. A company generating high rates of return on equity with little or no debt has all the attractive qualities without the risk. Of course, there may be a point in time where debt needs to be held but when very high returns are being generated after the interest is paid, the debt usually isn’t held for long. By definition therefore, a quality business has a competitive advantage so powerful it doesn’t need to carry debt.

It wasn't that Buffett disliked technology

For years Buffett and Munger ran the line that they didn’t like technology and many commentators proffered the explanation they didn’t understand technology. I have never believed that. Two Mensa geniuses with a lifetime of business experience and photographic memories can pretty much back solve whatever they put their minds to.

Instead the issue with technology is the fast-paced nature of change, which makes the formation of a view about the future competitive landscape almost impossible with any certainty. If one cannot establish whether a business will be the long-term winner in a competitive environment it is impossible to say the business is 'easily understandable'' nor whether its earnings are 'virtually certain to be materially higher five, 10 and 20 years from now”.

That is fundamentally why Berkshire Hathaway has hitherto been devoted to businesses with predictable outlooks.

More recently, Berkshire invested in technology and is reported to own 245 million Apple shares, representing a stake of just under 6% in Apple worth US$114 billion at current market prices. It represents almost a quarter of Berkshire’s own market capitalisation of US$500 billion.

The position in Apple does not suggest Buffett has strayed from his oft-touted principles of investing. On the contrary, Apple along with its FAAMG peers (Facebook, Apple, Amazon, Microsoft and Google) harbour the very qualities that Buffett has insisted should characterize a portfolio.

Not only are the earnings of these companies growing at a rapid pace but as they grow, they are becoming more profitable. Returns on equity have increased for each of the five over the last four or five years.

The enduring appeal of the FAAMGs

I looked at the returns on equity for each of the FAAMGs for the last five years and discovered something universal; as these companies grew, they became more profitable.

In 2016, for example, Microsoft was earning US$20 billion on US$76 billion of equity – a return on equity of 27%. In 2020, Microsoft’s equity was a little more than 50% higher at US$110 billion but the company earned more than double its 2016 profits at US$44 billion. It therefore recorded a return on equity of 40%. Improvements in profitability, as measured by return on equity, similarly improved for the remaining four of the FAAMGs.

And in addition to benefitting from the network effect and flywheel competitive advantages, they have become monopolies in which inheres the most valuable of all competitive advantages. They have the ability to raise prices without a detrimental impact to unit sales volume. In a world of declining real rates of return, such pricing power and growth is scarce and highly prized by investors.

As an aside, in his book Monopolized: Life in the Age of Corporate Power author, journalist and Executive Editor of one of the most important political magazines today, the American Prospect, Dave Dayen notes that practically everything we buy, everywhere we shop, and every service we secure comes from a heavily concentrated market.

In a recent interview about monopoly power in the US, Dayen comments on Buffett:

“This is a guy whose investments philosophy is literally that of a monopolist. I mean, he invented this sort of term, the economic 'moat', that if you build a moat around your business, then it's going to be successful. I mean, this is the language of building monopoly power. He not only looks for monopolies in the businesses he invests in, but he takes it to heart in the business that he's created, Berkshire Hathaway. Berkshire Hathaway owns something like 70 or 80 or 90 companies and they have large market shares in all sorts of areas of the economy”, adding, “It's kind of like an old school conglomerate from the sixties and seventies, but there are certain facets of it, where he's clearly trying to corner a market. Buffett's initial businesses that he actually outright purchased were newspapers. It started with the Buffalo News in Buffalo, New York. And he used anti-competitive practices to put the competition, his rival newspaper, out of business. That was literally his MO there.”


Register here to receive the Firstlinks weekly newsletter for free

Elements of monopoly and anti-competitive behaviour

The FAAMG stocks demonstrate at least some of the hallmarks of monopoly power and some of these companies, as well as their peers and counterparts, engage in anti-competitive behaviour.

Most recently, I read Spotify’s developer agreement. Yep, Fun! In Section IV Restrictions, Part 1 General Restrictions, clause 1.f. reads:

“Do not use the Spotify Platform, Spotify Service or Spotify Content in any manner to compete with Spotify or to build products or services that compete with, or that replicates or attempts to replace an essential user experience of the Spotify Service, Spotify Content or any other Spotify product or service without our prior written permission.”

Many would argue this is blatantly anti-competitive. Another business, therefore, might not be able to build a tool that transfers a user’s list of songs from Spotify to another service provider even if the consumer and the artists who produced the songs might benefit from the transfer.

While the presence of such behaviour puts these companies in the sights of future anti-trust action and therefore generates new risks for investors (we’ll hear more about that in coming years) the popularity of their shares with investors has spilled over to other technology companies that have not demonstrated the ability to generate sustainable high returns on equity.

Not all technology companies have 'virtually certain'

Indeed, in the next tier of technology companies - and those companies in the many tiers below that – they don’t generate a profit and some don’t even generate revenue.

What is happening here is that low interest rates have made it appear safe to pursue growth at the expense of all else. The popularity of the strategy has led to a self-fulfilling and virtuous spiral where success reinforces the validity of the approach. Consequently, investors are pursuing growth irrespective of whether the company displays the quality characteristics required to sustainably generate highly profitable growth. The absence of profit or even revenue is not a hurdle to investment success and therefore not relevant.

Take for example, Hyliion, a Texas-based truck electrification business, founded by 28-year-old Thomas Healy. While the company is not expected to generate revenue from supplying aftermarket hybrid and electric thrust systems for long-haul trucks until at least 2022, it hasn’t stopped a merger with cash-box Special Purpose Acquisition Company (SPAC), Tortoise Acquisition Corp, effectively valuing Hyliion at US$7 billion. There are many other examples. 

While investors are happy to pay top dollar for leading online companies, Buffett’s lesson about quality and certainty of future growth should not be forgotten. Revenues may be growing but you want to own a business whose earnings are virtually certain to be materially higher in five, 10 or 20 years from now.

Note the imperative 'virtually certain' about earnings or profits. One can only be ‘virtually certain’ if in addition to growth the company has a sustainable competitive advantage. In the absence of high barriers to entry, defendable intellectual property or monopoly conditions, the sustainability of highly profitable growth is in question.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

8 Comments
matthew
November 08, 2020

Great theory. Putting it into practice somewhat more difficult. Ray Dalio keeps emphasizing you will never get it absolutely right, the world is just too unpredictable so diversify.

Stella
October 24, 2020

Thanks, Roger. This a great article for discussion with teenage grandchildren.

SN
October 22, 2020

Well said JB your comment is highly appreciated.

In my opinion only One and only One can decide when to Buy or Sell.
Past history and recommendation are only noise !

Robert
October 22, 2020

Thank You Roger, good reading.

CC
October 22, 2020

ah yes, the old chestnut "If you aren’t willing to own a stock for ten years..."
as if anyone can predict the future that far ahead. honestly who would have predicted accurately the massive disruption being caused by online shopping, electric cars, cashless purchasing etc . the world is a different place now.

Daryl
October 22, 2020

Well I’ve many including BRKbs I’ve done very well with T-You Warren! Maybe U need to look a little deeper as Warren & Charlie Clearly do. Our God Daughters investment improved 7 fold in 21 years and was never added to!

JB
October 22, 2020

Well if you'd paid US$400 for Tesla (a supposed "disruptor") and just got 0.55 in earnings. How long do you think you'd need to own it to get your money back? Price behaviour of these "disruptors" would suggest that investors (assuming they are rational - ha!) actually think they can predict further ahead than Warren Buffet's 10 yrs...

I have the same question for the average Afterpay (another supposed disruptor) "investor": "When will you cash out?" The company has no earnings, makes nothing tangible, and PayPal could eat it for morning tea, so what is their thinking around when they will get their money back?

We are where we are with valuations because of low interest rates and few attractive investment alternatives, and that has lead to gambling, not investing. People are confusing price momentum with disruption. If you want to buy into "disruption" then it needs to be real and sustainable, and not just perceived. Online shopping is still just shopping. Electric cars are still just cars (ask VW and Daimler if they are worried about Tesla). And cashless purchasing is as old as Diner's Club. Not much real disruption here....

JP
October 25, 2020

JB, very well put. As for " Electric cars" - well, the energy still has to come from somewhere, such as a reliable fossil fuel powered grid in most countries for decades to come.

 

Leave a Comment:

     

RELATED ARTICLES

Why it's a frothy market but not a bubble

Four fruitful themes show plenty of juice in the market

Will 2022 be the year for quality companies?

banner

Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.

Shares

2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes.

Gold

Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inflation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.

Shares

What were the big stockmarket listings in record 2021?

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.

Economy

Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent about the build up of debt, but at some level, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.