As the UK emerges from the Covid-19 pandemic and shops and hospitality venues open up, many investment commentators have been urging us to buy into the inevitable business upswing in the retail, pub and restaurant sectors of the stockmarket. The annual UK Consumer Prices Index rose from 0.7% in March to 1.5% in April 2021, and with talk of labour shortages, chip shortages and delivery surcharges, commentators have also been recommending investment in commodities to ride the impending inflationary boom. Whether or not these strategies prove right in the short term, there remains the question of how long-lived these trends will prove. Are these shortages just a consequence of the world getting back to work? Or has government intervention on a huge scale during the pandemic unleashed forces which will permanently undermine the value of fiat money? Macro-economic forecasting is tricky at the best of times, and applying it to equity investing even more so. Investing with a much longer-term time horizon into businesses achieving sustainably high ungeared returns on equity is a more reliable (and less stressful) strategy.

The world’s most successful investor, Warren Buffett, certainly takes the long view. In his 1983 Chairman’s letter, for example, he commented that he had no interest at all in selling any good business that Berkshire Hathaway owned. He does of course have the advantage of permanent capital enhanced by regular cash flows from an insurance float (insurance premiums coming in monthly or annually), and mainly owns 100% of the businesses he invests in.

One of Buffett’s early acquisitions, See’s Candies, illustrates that investing in the right business over the long term renders macro-economic fluctuations unimportant and dwarfs any change in market valuation metrics (e.g. PE multiples).

In his 2007 Chairman’s letter, Buffett revealed that Berkshire Hathaway had purchased See’s Candies back in 1972 for $25 million. He remarked that at that time it was earning about $2 million on net tangible assets of $8 million, selling branded boxed chocolates mainly on the West Coast of America. So Berkshire paid about 3x book value and a 12.5x PE. Revenues in 1972 were about $30 million and pre-tax profits said to be a bit less than $5 million. So profit margins were in double figures, and return on equity an attractive 25%.

Roll forward 35 years, and Buffett revealed that See’s Candies was now achieving revenues of $383 million, and pre-tax profits of $82 million, increases of 12-and 16-fold respectively! Crucially, only an additional $32 million of capital had been required over that entire 35 years to generate total pre-tax profits of $1.35 billion!

Clearly if you can invest in a business earning high returns on equity and grow it with virtually no extra capital requirements, the returns are immense. Any increase in the PE multiple (we can only speculate on that as Berkshire’s valuation of See’s Candies is not disclosed) looks to have been dwarfed by the growth achieved in the business.

The story of See’s Candies demonstrates the importance of hunting out businesses with sustainably high returns on equity made possible by low capital requirements and enduring barriers to competition. It is hard over the long term for a stock to earn a much better return for the shareholder than the return on equity of the business that underlies it. If you invest in a low return business that has recently cut costs or is about to see a cyclical upswing, in the short term you may make a gain. But longer term, any business will trade at a valuation that bears some relation to its net asset value. If it cannot generate much in the way of retained profits on those assets, after interest, taxes and dividends are paid out, then the asset value won’t grow a great deal, and ultimately over the long term neither can the share price. So you have the pressure of needing to sell out again, or see any short term gains stall or reverse.

Given the record of Berkshire Hathaway, and the very clear message that their success is derived from investing in businesses which compound upwards high returns on assets, it is surprising that the vast majority of investors in the UK today focus on PE multiples rather than returns on equity. Not all earnings are created equal, and some require a lot more capital in their generation than others. Moreover, if the UK is set for a prolonged period of higher inflation, as many pundits predict, inflation-beating returns are also more likely to be earned by companies with low capital requirements and the pricing power to pass on any cost increases promptly.

That is just about the long and the short of it.

For more information about Rosemary Banyard, Fund Manager of the VT Downing Unique Opportunities fund please visit: downingunique.co.uk

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