The Gift of Capital Efficiency

Warren Buffett is one of the richest men in the world, worth an estimated $46 billion.

He earned virtually all of his wealth investing. He started early, making his first big investment at age 14. He spent $1,200 he earned on his paper route to buy 40 acres of farmland, which he rented to tenant farmers.

Buffett went to Columbia’s business school and studied under Ben Graham, the legendary dean of value investing. After a short stint working for Graham in New York, Buffett launched his first investment partnership, Buffett Associates Ltd. in 1956. He was 26 years old. He contributed $100 to the fund and served as its general partner. The vast majority of the partners’ capital ($105,000) came from Buffett’s family and friends.

Buffett invested these funds based on Graham’s value approach – buying stocks that were trading for less than their liquidation value. He also engaged in merger arbitrage opportunistically. Buffett’s partnership earned more than 30% annually, beating the Dow Jones Industrial Average every year, until he closed it in 1969, distributing shares of textile maker Berkshire Hathaway in the process. The partnership produced a 2,749% total return. And early investors who decided to hang on to their Berkshire Hathaway shares soon saw fantastic gains...

Buffett began to acquire shares in the textile company in 1962 (when Buffett was only 32 years old) because it was trading for far less than its liquidation value. Buffett soon found out why: It was a terrible business that needed constant capital improvements to remain competitive. 

In 1965, he took control of Berkshire. After gaining control of the business, rather than continuing to invest in the firm’s textile operations, he used the company’s cash flow to buy stakes in other companies - insurance companies in particular. After closing down his partnerships in 1969, Berkshire became Buffett’s main investment vehicle. Berkshire has beaten the S&P 500 in 36 out of 41 years, earning a total return of 305,134%.

Buffett’s track record, particularly since the spin-off of Berkshire, is the best example of the power of compound returns put to work through high-return common stocks. If you had put $10,000 into Buffett’s first investment partnership and held until today, your $10,000 would have turned into $366 million.

I’ve heard many investors say, “I’m too old to use that long-term approach.” That’s probably not true. You might not be patient enough, but you’ve most likely got plenty of time. It wasn’t until 1972 (when he was 42) that Buffett used a new approach to value investing to buy See’s Candy. Buffett’s new approach focused on buying companies capable of greatly increasing their earnings without spending much additional capital.

Buffett’s secret – capital efficiency – is this: He looks for companies with an unusually high return on net tangible assets where those returns occur in the face of ongoing and well-financed competition and where those returns don’trequire large, ongoing capital investments. It is the sustained and unusually high returns on assets that are the secret engine of Berkshire Hathaway’s successful investment portfolio.

Buffett’s most famous investment in this style came in 1988 – when he was 58 years old. He acquired nearly 7% of Coca-Cola (KO), paying more than $1 billion. Coca-Cola is one of the great all-time stories of capital efficiency. Today - on $12 billion in net tangible assets - Coke earns nearly $5 billion per year. That’s a 41.6% return on net tangible assets. Imagine a mutual fund that could earn that high a return, year after year.

Budweiser’s (BUD) numbers are even more impressive. The company has roughly $2 billion in net tangle assets and earned $1.8 billion last year – a 90% return on net tangible assets. Those incredible returns are why readers of my newsletter are up 20% in less than a year in Budweiser... in a safe a stock as you’ll ever buy.

Could Buffett’s approach work for you? I believe the answer is “yes, absolutely.” In fact, Buffett’s approach is steeped in simplicity. If you can identify long-lasting, iconic businesses and know one or two things about accounting, Buffett’s approach is a sure-fire path to wealth. The hard part, in fact, is fighting off the boredom.

Buffett’s secret – the secret to long-term investing – is to buy companies that have outrageously high returns on net tangible assets and that have management teams that are committed to returning excess capital to shareholders. 

If you do nothing but focus on companies who do this, you’ll always make money in stocks.