The Quality Series · part 6 of 13
Munger made a point I have never been able to improve on. If a business earns 6% on its capital over forty years and you hold it for forty years, you will not do much better than 6%, even if you bought it cheaply. If it earns 18%, you will do well, even if you paid what looked like a high price.
Over a long enough period, the return the business earns (i.e. the free cash flow it generates) on its own capital becomes the return you earn on yours.
That is why three of my questions sit together. Does the business have a consistent record of high returns on capital — not one good year, many? Does it show operating leverage, meaning profits growing faster than sales as fixed costs are spread over more revenue? And is there a long runway left, room to keep reinvesting at those returns far into the future?
The third is where most mistakes hide. A business can earn superb returns on a small base and have nowhere left to put the money. What I am really hunting for is a young compounder: high returns, high growth, and years of road still ahead. A mature one can still be a good holding. But the outsized returns typically come from finding them early.
So when I compare two businesses at the same price, I am not asking which is growing faster this year. I am asking what happens to each dollar of profit the business retains rather than pays out. That dollar is put back to work at the business’s own return on capital, and what it earns is put back to work in turn. Reinvested at 18% a year for ten years, a dollar becomes about $5.20; at 6%, about $1.80. The higher that return, and the more years the business can keep reinvesting at it, the bigger the gap.
Two businesses at the same starting price, one earning 6% and one 18% on capital, ten years on.
Which raises a fair question: what if I pay up for quality? Take three businesses with the same profit today, each putting 80% of it back to work. A earns 20% on its capital, and the market prices it at a multiple of 25 times profit. B earns 12% and costs 20 times. C earns 6% and costs only 15 times. If each keeps its multiple, over ten years A returns about 17% a year and C about 6%.
Now take the worst case for A: the market marks it down to 15 times, while C, the business with the lowest return on capital and therefore the cheapest, is marked up to 20 times — an unlikely scenario. A still comes out ahead, 11.2% a year against 9.0%.
The one assumption is that each business keeps earning its return on the new money it puts back. That is exactly what the runway question tests.
Next: what a moat looks like in practice — and the one test I use for it.
The series so far
- Part 1: The whole idea, in one line
- Part 2: Same five years, very different businesses
- Part 3: From great business to great investment
- Part 4: Where stock returns actually come from
- Part 5: The secret sauce
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This is my personal investing journal, written for information only. It is not investment advice or a recommendation to buy or sell any security, and it does not take account of your circumstances. I may own shares in companies I write about. Past returns are no guide to future returns.
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