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When Warren Buffett was asked to distill the essence of investing success, he offered the following:
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
I am wedded to a relatively strict idea about what a quality business is. A company should sustainably produce high returns on equity with little or no debt. Why? Because it suggests the company has a competitive advantage.
You see, when companies generate high rates of return, they attract competition. The easiest and most mindless way for new entrants to compete is to offer cheaper prices, which of course reduces gross margins, putting pressure on net margins and therefore returns on equity. If a company can generate a high rate of return on equity sustainably it has been able to fend of the competitors or sufficient barriers to entry exist to block or slow their entrance in the first place.
A high level of debt relative to equity can artificially boost the returns on equity but of course debt carries risk. A company generating high rates of return on equity with little or no debt has all the attractive qualities without the risk. Of course, there may be a point in time where debt needs to be held but when very high returns are being generated after the interest is paid, the debt usually isn’t held for long. By definition therefore, a quality business has a competitive advantage so powerful it doesn’t need to carry debt.
For years Buffett and Munger ran the line that they didn’t like technology and many commentators proffered the explanation they didn’t understand technology. I have never believed that. Two Mensa geniuses with a lifetime of business experience and photographic memories can pretty much back solve whatever they put their minds to.
Instead the issue with technology is the fast-paced nature of change, which makes the formation of a view about the future competitive landscape almost impossible with any certainty. If one cannot establish whether a business will be the long-term winner in a competitive environment it is impossible to say the business is 'easily understandable'' nor whether its earnings are 'virtually certain to be materially higher five, 10 and 20 years from now”.
That is fundamentally why Berkshire Hathaway has hitherto been devoted to businesses with predictable outlooks.
More recently, Berkshire invested in technology and is reported to own 245 million Apple shares, representing a stake of just under 6% in Apple worth US$114 billion at current market prices. It represents almost a quarter of Berkshire’s own market capitalisation of US$500 billion.
The position in Apple does not suggest Buffett has strayed from his oft-touted principles of investing. On the contrary, Apple along with its FAAMG peers (Facebook, Apple, Amazon, Microsoft and Google) harbour the very qualities that Buffett has insisted should characterize a portfolio.
Not only are the earnings of these companies growing at a rapid pace but as they grow, they are becoming more profitable. Returns on equity have increased for each of the five over the last four or five years.
I looked at the returns on equity for each of the FAAMGs for the last five years and discovered something universal; as these companies grew, they became more profitable.
In 2016, for example, Microsoft was earning US$20 billion on US$76 billion of equity – a return on equity of 27%. In 2020, Microsoft’s equity was a little more than 50% higher at US$110 billion but the company earned more than double its 2016 profits at US$44 billion. It therefore recorded a return on equity of 40%. Improvements in profitability, as measured by return on equity, similarly improved for the remaining four of the FAAMGs.
And in addition to benefitting from the network effect and flywheel competitive advantages, they have become monopolies in which inheres the most valuable of all competitive advantages. They have the ability to raise prices without a detrimental impact to unit sales volume. In a world of declining real rates of return, such pricing power and growth is scarce and highly prized by investors.
As an aside, in his book Monopolized: Life in the Age of Corporate Power author, journalist and Executive Editor of one of the most important political magazines today, the American Prospect, Dave Dayen notes that practically everything we buy, everywhere we shop, and every service we secure comes from a heavily concentrated market.
In a recent interview about monopoly power in the US, Dayen comments on Buffett:
“This is a guy whose investments philosophy is literally that of a monopolist. I mean, he invented this sort of term, the economic 'moat', that if you build a moat around your business, then it's going to be successful. I mean, this is the language of building monopoly power. He not only looks for monopolies in the businesses he invests in, but he takes it to heart in the business that he's created, Berkshire Hathaway. Berkshire Hathaway owns something like 70 or 80 or 90 companies and they have large market shares in all sorts of areas of the economy”, adding, “It's kind of like an old school conglomerate from the sixties and seventies, but there are certain facets of it, where he's clearly trying to corner a market. Buffett's initial businesses that he actually outright purchased were newspapers. It started with the Buffalo News in Buffalo, New York. And he used anti-competitive practices to put the competition, his rival newspaper, out of business. That was literally his MO there.”
The FAAMG stocks demonstrate at least some of the hallmarks of monopoly power and some of these companies, as well as their peers and counterparts, engage in anti-competitive behaviour.
Most recently, I read Spotify’s developer agreement. Yep, Fun! In Section IV Restrictions, Part 1 General Restrictions, clause 1.f. reads:
“Do not use the Spotify Platform, Spotify Service or Spotify Content in any manner to compete with Spotify or to build products or services that compete with, or that replicates or attempts to replace an essential user experience of the Spotify Service, Spotify Content or any other Spotify product or service without our prior written permission.”
Many would argue this is blatantly anti-competitive. Another business, therefore, might not be able to build a tool that transfers a user’s list of songs from Spotify to another service provider even if the consumer and the artists who produced the songs might benefit from the transfer.
While the presence of such behaviour puts these companies in the sights of future anti-trust action and therefore generates new risks for investors (we’ll hear more about that in coming years) the popularity of their shares with investors has spilled over to other technology companies that have not demonstrated the ability to generate sustainable high returns on equity.
Indeed, in the next tier of technology companies - and those companies in the many tiers below that – they don’t generate a profit and some don’t even generate revenue.
What is happening here is that low interest rates have made it appear safe to pursue growth at the expense of all else. The popularity of the strategy has led to a self-fulfilling and virtuous spiral where success reinforces the validity of the approach. Consequently, investors are pursuing growth irrespective of whether the company displays the quality characteristics required to sustainably generate highly profitable growth. The absence of profit or even revenue is not a hurdle to investment success and therefore not relevant.
Take for example, Hyliion, a Texas-based truck electrification business, founded by 28-year-old Thomas Healy. While the company is not expected to generate revenue from supplying aftermarket hybrid and electric thrust systems for long-haul trucks until at least 2022, it hasn’t stopped a merger with cash-box Special Purpose Acquisition Company (SPAC), Tortoise Acquisition Corp, effectively valuing Hyliion at US$7 billion. There are many other examples.
While investors are happy to pay top dollar for leading online companies, Buffett’s lesson about quality and certainty of future growth should not be forgotten. Revenues may be growing but you want to own a business whose earnings are virtually certain to be materially higher in five, 10 or 20 years from now.
Note the imperative 'virtually certain' about earnings or profits. One can only be ‘virtually certain’ if in addition to growth the company has a sustainable competitive advantage. In the absence of high barriers to entry, defendable intellectual property or monopoly conditions, the sustainability of highly profitable growth is in question.