Thursday, August 4, 2016

Buffett: The Growth Investor?

I recently had the chance to read another book on Buffett. This one had a few interesting insights.
I’ve been plowing through number of investment focused books recently. There’s been Common stocks Uncommon profits by Philip Fisher, William Hagstroms “The Warren Buffett Way”. Most recently I had the chance to read Buffett: Beyond Value by Prem Jain.
This book on Buffett is quite interesting because it casts buffet as an investor who is able to strike the optimal balance between growth and value. The book makes a very interesting point that if Buffett’s investments are analyzed at the time that they’re made then they take on the appearance of growth investments, given the rate of growth these companies at the time Buffett made investments.
Certainly looking at Buffett’s purchase of Coca-Cola and Geico at the time that both of these were made suggests a focus on long-term earnings growth. Coca-Cola was growing so strongly at the time that Buffett made his investment that it was experiencing a double-digit rate of growth in earnings in excess of 17%.

The most interesting thing about the time the buffet made his investment in Coca-Cola was that Coca Cola’s international expansion strategy was just getting underway. What I took away from Buffett’s investment in Coca-Cola was that while Coca Cola was rapidly growing, the company was priced at a very reasonable earnings multiple compared to its future expected earnings growth.
This helps illustrate the value investor elements of Buffett’s strategy. At the time that Coca-Cola was purchased by Buffett, Coca Cola’s price-to-earnings ratio was significantly above the median of the S&P 500.
However compared to its earnings prospects it wasn’t outrageously priced. In fact Coca-Cola’s P/E ratio at the time was a relatively modest 17 x earnings. For a company that’s expected to grow earnings double digits this can be argued to have been a fair price. It could also be argued that given Coca-Cola’s lengthy historical record of successful growth in revenue and earnings, that the downside to Buffett making such a large investment was a prudent illustration of the value investor in him.
McDonalds is another interesting business that Buffet purchased in 1995. From the time between 1990 and 1999, McDonalds increased revenues almost 2.5 times. Clearly another growth business in terms of its earnings profile at the time.
The other interesting thing that the book also revealed was the large number of smaller private companies that Berkshire acquired over time. In fact the listed equity holdings of the portfolio are actually only a small percentage of the overall investment volume within Berkshire Hathaway. Buffett has made a string of purchases of smaller businesses with fairly robust earnings growth but the interesting thing to note is that all of these businesses were acquired at quite modest prices relative to that expected earnings growth. From my analysis of some of these investments which are highlighted in the book it appears that low double-digit earnings growth was typically the sweet spot for many of Buffett’s purchases, with earnings multiples of these purchases also in the low double digits as well.
Most interesting was that Buffett never seems to have gone out of his way to purchase more early-stage, hyper growth businesses.
Rather he’s always happy to have gone to businesses with a lengthy track record to demonstrate some level of consistency and then looked to purchase those businesses at a fair price. I speculate that the faster growth businesses typically didn’t have the long-term consistency and predictability of earnings that Buffett was looking for. Also these businesses probably were unable to demonstrate the track record of repeatability that appears so important to him and his investment selection.
I believe its also likely he was never able to get these businesses at reasonable PE multiples. It made me wonder whether there is a sweet spot for growth, with companies generating 15-20% earnings growth, with PE multiples no greater than 20-25. At rates of growth beyond this, multiples shoot up, but the problem becomes that this growth isn’t sustainable, such that PE compression occurs and the investment doesn’t earn a good long term return.
Based on my read of the book and the time when Buffett made his various investments in Coca-Cola and Procter & Gamble I wonder whether he would consider making the same investments today
Clearly the nature of these businesses at this point in time are very different to when he made those investments. That’s not to say that their moats have necessarily eroded, but rather the consistent double-digit earnings growth of these businesses no longer seems to be there.
Procter & Gamble for instance has struggled to grow earnings in any significant major goal for much of the last ten years. In fact the company is actively undergoing a program of shedding a number of its brands given how bloated the organization has become.
In Coca Cola’s case, carbonated beverage volumes have been consistently falling in North America for the last few years and with it Coca-Cola’s earnings growth and earnings profile seems to have moderated somewhat.
Of course it makes complete sense for Berkshire to hang onto these investments at this point in time given the hefty capital gains that have accumulated. I do wonder however whether these same investments would see substantial new investment from Buffett today.
Buffett Beyond Value was a very interesting read for me.
The key points I took away from that book are that a steady rate of earnings growth matters to Buffett and it should matter to most investors. It’s clearly the pathway to long-term investment success. Having said that the price that one pays for that earnings growth is also an equally important element. Ensuring that you don’t pay to high a price will mean that you protect your downside when you’ve invested in a company with a long-term track record.
That may help explain why the hyper growth stories of companies that are growing in excess of 30 to 40% annually and that have PE multiples in that region are something that’s best avoided by most investors. The prospects of generating a reasonable return on that type of an investment and the unlikelihood that a company can sustain that level of earnings growth for an extended period of time should give anyone pause.
Applied to my own portfolio, I feel the best about companies such as MasterCard and Visa which still look reasonably priced to me based on their long term earnings profile. These could be “Buffet stocks” and seem to be in the zone of price and earnings growth. There are a few others that have more elevated PE’s that I’m going to have to keep a closer eye on.

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  1. The Snowball: Warren Buffett and the Business of Life is the only book that I have read on Buffett. It was more biography driven than it was a study of his investing. I may have to check this book out. Thanks for sharing!

  2. Buffett once mentioned: Growth and Value are joined at the hip. He didn't say: Invest in companies that is growing dividend. Dividend growth is just a side effect of business grow. The secret is out long time ago as Buffett said, "A bird in the hand is worth 2 birds in the bushes", John Bur Williams book Theory of Investment and Security Analysis (1962 edition)


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