Issue No. 2: 'Paying Up' for a Great Business

Inspired by Gotham's purchase of Moody's and Buffett's purchase of Coca Cola

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

- Charlie Munger

The above Mungerism is an often relied on piece of mathematical wisdom for the quality/growth at-any-price crowd. Even the likes of Terry Smith uses this as a central justification for the purchase of individual securities. It is worth a little dissecting.

Over long periods of time, it is extremely rare for a company to earn 18% on capital. This is easily explained by competition, management incompetence, the lack of adequate reinvestment opportunities and redundancy in products. History is replete with examples of the proverbial economic gold mine running dry.

It’s also an observable fact. Long term (close to 100 year) industry returns seem to cap out at about 17%, for even the most outstanding industries. That is of course remarkable - but we can see the kind of economic gravity we are dealing with here.

Munger’s wisdom relies on a second assumption: that you are able to accurately predict the next 20 or 30 years of returns. No easy feat, irrespective of how insightful your analysis is. This explains Buffett’s almost semi-religious focus on durable competitive advantage: if you can’t accurately predict the next 10 or 20 years of cash flows, you can’t value a company.

I’ll save you, dear reader, from my internal monologue (read rant) on how Buffett’s wisdom is used to justify all kinds of speculative activity. For now anyways. The fact remains that Buffett, and investors of his ilk, have paid optically expensive near term prices for businesses of outstanding quality. The wisdom of doing so was justified both in their share price, and in the performance of the underlying business post facto. So, if you are inclined to quality, value, business ownership, and a long-term (if not perpetual) holding period, how could you not be interested in making sense of seemingly high prices?

I most certainly am.

Gotham’s Explanation of their Investment in Moody’s (LINK)

While Buffett is notoriously coy about explaining the minutiae of his investment rationales - others are not so unwilling. I thank them.

Below will be a number of quotes from Rob Goldstein, Joel Greenblatt’s partner at Gotham Capital. The quotes are derived from one of Joel’s lectures at Columbia University. As Gotham is well known for it’s legendary long-term performance I will not spend any amount of time explaining their history.

The opening from Rob is illuminating:

We came across Moody’s in 2000 when it was in the early stages of being spun off and it became clear to us that it was one of the greatest businesses we had ever come across.

For context, Moody’s was spun out of Dun & Bradstreet in 2000 after a multi-decade ownership period. That event has turned out to be one of the greatest value creation opportunities in the past few decades.

JG later explains that Moody’s was in fact a top 5 business of all time (in his opinion).

While I will expand on how Rob defines quality a bit later, the first consideration here is the strength of the franchise. If you aren’t struck by how awesome the economics of a business are, it’s probably not worth considering until it’s in the bargain bin.

Continuing on:

The problem was that it was trading at 21x forward earnings, and 24x trailing earnings. So the question we had to ask ourselves was: how much of that greatness was already baked into the stock price?

Rob uses the paradigmatic example of Buffett’s purchase of Coca Cola in the late 1980s:

Several decades ago, Buffett figured out that if he identified a really great business he could pay what seemed like a lot of money and still make a fortune. In 1988, Buffett bought $600M of Coke stock. He paid around 13x forward earnings [and] 15x trailing earnings and back then the value investing community didn’t understand how that was any great bargain. 12 years later that $600M was worth over $7B.

Rob goes onto explain what made Coca Cola such an outstanding franchise. For the sake of brevity, these are:

• Organic Growth: the ability to grow the business with very little or no capital.

• High Return on Equity: favourable business economics.

• Lasting Competitive Advantage: durability of the franchise.

• Easy to Understand & Predict: it isn’t hard to understand what the future cash flows will be.

This is not an exhaustive list by any means, but it is a good place to start. The purpose of using these characteristics as a filter would not be to identify great businesses, but rather to disqualify the mediocre ones.

This is where ones qualitative research should begin - the journalistic or historical process. Rob goes onto briefly outline the circumstances that resulted in the above characteristics:

Now Moody’s was founded in the early 1900’s and revenue originally came from bond investors who paid Moody’s for bond ratings. In the 1970’s the industry changed and the ratings agencies began to charge issuers as well as investors. This change was a huge deal for Moody’s. The ratings agencies had such clout with investors that debt issuers were forced to pay for their ratings or face significantly higher borrowing costs in the market.

As many investors will know, Moody’s now accounts for something like 40-45% of all Western debt ratings. S&P Global shares a similar market position, with both agencies often used to rate the same new issue. The debt markets are naturally orders of magnitude larger than equities markets for the simple reason that many more companies need access to debt financing than equity capital. These two companies are basically a toll booth to the largest markets on the planet - a position that is reinforced by allowing their customers to reap significant cost savings.

I repeat, if not a little differently: If you aren’t struck by how awesome the market position of a business is, it’s probably not worth considering until it’s in the bargain bin.

A discussion of Moody’s historical financials ensues:

In the 19 years to 2000, the revenues had grown at a compounded annual rate of 15% and operating profits had grown at a compounded annual rate of 17%. Not many companies have that kind of terrific performance. In that 19 year, period revenue had only declined 1 time year-over-year, and then it was only a few percentage points.

This is an amazing track record of performance, but JG and Rob go onto to discuss how this may relate to future performance - we’re back to the qualitative:

No matter what you did it would be impossible to start another [credit ratings] business. In addition you’d need to have the confidence of the financial markets and you’re not going to get that either. It’s a chicken or egg thing, you have two credible players and it’s just not going to happen.

This sentiment harkens back to how Buffett looks at the qualitative characteristics of a company. He’s looking for businesses where excellence has been institutionalised - i.e. replicable time and again by one organisation. He’s also looking for situations where the business got lucky once*, not businesses that require luck or skill over and over again.

As Rob explains, the actual business risk that faced the company was approaching 0. Again a very high bar for consideration:

30 (46 now) years ago when you got a loan, that lending institution would retain the loan. Today the majority of loans are on-sold to the capital markets. The guy originating the loan now isn’t necessarily financing the loan. Today there are trillions of dollars of these securities… and to do these securitisations you need ratings. Financing loans through the capital markets is more efficient than the old way, and one would expect that this growth would continue. In addition, Europe was way behind the US in terms of securitisations, and Asia was way behind Europe.

On pricing, generally speaking the ratings agencies will charge corporates a recurring fee for an ongoing relationship, as well as a infinitesimal percentage of any debt issue. Again, Moody’s economic cache is that when a firm uses their ratings the cost of their debt will be lower in the market. Hence, so long as there is a delta between the cost savings of a debt issue and what Moody’s charges, there will be a legitimate and self reinforcing creation of value. As debt issues get larger over time (as is bound to be the case), it also means that this economic goodwill grows - growth that can fund significant pricing increases, especially as these initial costs were low in relation to value.

Now, to turn back to Buffett and Coke:

The question is: why did Buffett do so well on is Coke investment?… Over the ten year period [after Buffett purchased] unit case volumes grew 7% - organic growth - 5% pricing growth which equated to 12% operating income growth. There was a bit of leverage so they got 13% net income growth and they bought back stock so they got 15% EPS growth over that time. The other reason he did so well was because… he only had to reinvest 20% of the earnings back into the business, so that means in addition to the buybacks, he was able to pay out dividends.

Additionally, Buffett experienced multiple expansion on the quoted price of his Coca Cola shares. For the 12 year period from 1988 to 2000 he experienced a 23.7% annual compounded rate of return in Coca Cola. So that gives us a basis for how to think about extrapolating past performance forward: volumes +/- pricing +/- buybacks = EPS growth. Add dividends plus leverage and you can find a prescriptive total stock return.

Rob then continues to expand on how they used this understanding to evaluate Moody’s on a look forward basis:

So how can we expect Moody’s to perform for us over the next 12 years? What growth rate should we assume?… We settled [on a growth rate] of 12%. The reason we settled on 12% is because 1). management guidance was low single digits, and 2). 12% seemed very reasonable given the historical operating performance. We had the belief that the same factors that had informed past performance were going to continue. Now, anytime you evaluate a company for the first time you need to make these key valuation assumptions and part of the learning process is to hear management’s learning assumptions.

On management’s guidance:

Usually you’ll find that management’s rosy outlook is built on assumptions you wouldn’t want to bet on but occasionally there will be some very obvious reasons why a company is very likely to reach those bullish expectations and that was the situation with Moody’s. We felt very comfortable with our expectations [in this case]… Now our estimated 12% operating income growth rate was very convenient because that was Coke’s growth rate during those 10 years we looked at.

How the return on capital differed between Coke and Moody’s:

[Moody’s] return on capital was infinite because they had $15M in PP&E (Property, Plants, and Equipment), they only needed desks and computers for 2000 employees. In addition their customers paid on time or in advance. They were in a very strong position, they could demand payment upfront, and you typically see that kind of thing with companies that earn good returns on capital.

Coke needed to spend 20% of it’s earnings on growth. So Coke would earn 1$, spend 20c, and you would have 80c left over. Moody’s would spend nothing and they would have 1$ left over. So how much more was Moody’s earnings stream worth than Coke’s? 25%. Now does this mean that the higher return on capital means that it’s worth 25% more than Coke?…

I’ll interject here to discuss a little maths. This isn’t my strong suit so bear with me:

ROE = Growth Rate/Reinvestment Rate

When Rob compares the difference in the two earnings streams based on the observation that Coke had to reinvest a portion of it’s earnings, while Moody’s did not - he also assumes that Coke’s extraordinary growth rate would eventually mean revert to GDP + 1-2% at some point in the future. This would mean that Coke’s pay-out ratio would increase, as the total percentage of earnings required to fund growth would decrease. The mathematical explanation for this is as follows:

For the duration of Buffett’s the investment in Coke the operating income growth rate was 12%, and the reinvestment rate was 20%:

ROE = .12/.2

.12/.2 = .6

Cokes ROE = 60%. Assuming that Coke’s long term operating income growth rate reverted to 5%, the eventual payout ratio can be derived by rearranging the formula:

Reinvestment Rate = Growth Rate/ROE

.05/.60 = .083

The long term reinvestment rate would be = 8.3%

Gotham’s logic was to split the difference in the near term reinvestment rate for Buffett’s Coke investment and the far dated assumed reinvestment rate. They came to the decision that 1$ of Moody’s earnings were worth 15% more than a dollar of Coke’s earnings.

On management, the executive team of the soon-to-be spun out Moody’s fully comprehended the accretive nature of share repurchases (they intended to return all excess capital), and were fully aware of what the growth opportunity was in front of them. They grasped that they had to do very little in terms of corporate actions to have fantastic business results and were going to be compensated in line with that understanding. Rob and JG felt that there was a low probability that the management would team would squander what they already understood to be one of the great economic mousetraps. Additionally, Buffett owned 10% of the company and he had been communicating with management about the capital allocation strategy.

So, how did they put this all together:

What would have happened if back in ‘88 Buffett paid 18x forward earnings for his stock? He still would have done great. He would have made 8x his money and achieved a 20% annual compounded growth rate over the proceeding 12 years.

The above statement assumes that Gotham could have paid a 40% higher multiple than Buffett did with Coke on a forward basis, and still achieve a 20% annual compounded growth rate. Apologies, but more maths:

Moody’s earnings stream was worth 15% more than Coke’s so you can could pay an additional 15% more on your purchase of Moody’s:

13 x 1.15 = 14.95 (we’ll round up to 15)

Gotham were looking to achieve a 20% annual compounded return on their investment instead of Buffett’s 23.7% on Coke - and as we have seen you could pay a 40% higher multiple to do so:

15 x 1.4 = 21

The reasoning here was that one could have paid 21x forward earnings for a business of Moody’s calibre and still make a fabulous return. This was the price that it was being implied at from the Dun & Bradstreet spin-out.

However, there is a factor we haven’t discussed yet, and that’s interest rates. Over Buffett’s 12 year ownership, the 10yr US Treasury declined from 9% to 6%. Interestingly, all things being equal, in a world where rates drop from 9% to 6%, securities are worth ~40% more. A corollary to the discount Gotham was willing to accept on this investment. Incidentally, JG has stated that he is willing to underwrite long-term discount rates at 6%. In our current world, that seems realistic, if not altogether conservative.

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Working backwards through the Coke investment gives us an idea of what assumptions would need to be necessary in order to pay up for a business. The first hurdle is of course quality itself. This should clear out great swathes of businesses, whose purchase should be reserved for the bargain bin. Secondly, one should walk through EPS + Dividend +/- multiple expansion expectations realistically. Having conviction here means having certainty in the predictability and durability of future cash flows. Thirdly using those assumptions you can print out your TSR, perhaps using a historical analogy if appropriate.

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That’s all for this issue - be sure to subscribe to keep up with the journey.

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