Berkshire Hathaway 2003 Annual Meeting Audience Question # 41

The ideal business is one that earns very high returns on capital and could keep using lots of capital at those high returns

Warren Buffett:

Number 4.

Audience Member:

Hi there. My name is Alex Rubalcava. I am a shareholder from Los Angeles.

I have a question about the financial characteristics of the businesses that you like to acquire and invest in.

In your reports and other writings, Mr. Buffett, you state that you like to acquire businesses that can employ a large amount of capital to high returns.

And in reading the writings and speeches of yourself, Mr. Munger, I’ve seen you say in Outstanding Investor Digest and other publications, that you enjoy investing in companies that require very little capital.

And I was wondering if these statements are at odds, or if they are two sides of the same coin? And if you could elaborate using Berkshire companies, that would be great.

Warren Buffett:

Sure. It’s a good question.

The ideal business is one that earns very high returns on capital and could keep using lots of capital at those high returns. I mean that becomes a compounding machine.

So if you have your choice, if you could put a hundred million dollars into a business that earns 20 percent on that capital… say 20 million… ideally, it would be able to earn 20 percent on 120 million the following year, and 144 million the following year and so on.

That you could keep redeploying capital at these same returns over time.

But there are very, very, very few businesses like that. The really… unfortunately, the good businesses, you know, take a Coca-Cola or a See’s Candy, they don’t require much capital.

And incremental capital doesn’t produce anything like the returns that this fundamental return that’s produced by some great intangible.

So we would love the business that earn… that could keep deploying, in fact, even well beyond the earnings. I mean we’d love to have a business that could earn 20 percent on a hundred million now. And if we put a billion more in it, it would earn 20 percent more on that billion.

But like I say, those businesses are so rare. There are a lot of promises of those businesses, but we’ve practically never seen one. There’ve been a few.

Most of the great businesses generate lots of money. They do not generate lots of opportunities to earn high returns on incremental capital.

You know, we can deploy X at See’s and earn a lot of money, but if we put 5X in we don’t earn any more money to speak of. We can earn high returns on X at The Buffalo News, but if we try to make it 5X we don’t earn any more money.

They just don’t have the opportunities to use incremental capital. We look for them, but they don’t.

So, the great… you’ve seen… I mean, we will talk theoretically about the businesses that can earn more and more money with incremental capital at high returns.

But what you’ve seen is that we’ve bought businesses, largely, that earn good returns on capital, but in many cases, have limited opportunities to earn anything like the returns they earn on their basic business with incremental capital.

Now, the one good thing about our structure at Berkshire is that we can take those businesses that earn good returns in their business but don’t have the opportunity for returns of those similar magnitude on incremental money, and we can move that money around to buy more businesses.

Normally, if you’re in the… take the newspaper publishing business, which has been a fantastic business over the years… you earned terrific returns on your own invested capital.

But if you went out to buy other newspapers, you had to pay a very fancy price, and you didn’t get great returns on incremental capital.

But the people in that business felt that the only thing they knew was newspaper publishing or media of one sort or another, so they felt that their options were limited.

We can move money anyplace that it makes sense, and that’s an advantage of our structure. Now, whether we do a good job of it or not’s another question, but the structure is enormously advantageous in that respect.

We can take the good business, the See’s Candy… See’s has produced probably a billion dollars pretax for us since Charlie and I wouldn’t have gone up 100,000, you know, back in 1972.

If we tried to employ that in the candy business we’d have gotten terrible returns over time. We would have gotten anything to speak of. But because we moved it around it enabled us to buy some other businesses over time, and that’s an advantage of our structure.

Charlie?

Charlie Munger:

Yeah. And if you take a business that is a good business, but not a fabulous business, they tend to fall into two categories.

One is the business where the whole reported profit just sits there in surplus cash at the end of the year. And you can take it out of the business and the business will do just as well without it as it would if it stayed in the business.

The second business is one that reports the 12 percent on capital but there’s never any cash. It reminds me of the used construction equipment business of my old friend, John Anderson. And he used to say, “In my business, every year you make a profit, and there it is, sitting in the yard.”

And there are an awful lot of businesses like that, where just to keep going, to stay in place, there’s never any cash.

Now, that business doesn’t enable headquarters to drag out all the cash and invest it elsewhere. We hate that kind of a business.

Don’t you think that’s a fair statement?

Warren Buffett:

Yeah, that’s a fair statement. We like to be able to move cash around and have it find its best use. And, you know… but that’s our job. And sometimes we find good uses.

It would be terrific if every one of our great businesses, and we’ve got a lot of great businesses, had ways to deploy additional capital at great rates, but we don’t see it.

And, frankly, you know, it doesn’t happen… I mean Gillette has a great razor and blade business, I mean, fabulous.

There’s no way they can deploy the money they make in the razor and blade business to keep putting more money in that kind of business. It just doesn’t take that kind of capital. They have to deploy some money of it, but it’s peanuts compared to the profits.

And the temptation then is to go out and buy other businesses, and of course that’s what Charlie and I do when we face that, but we don’t think that, overall, the batting average of American industry in redeploying capital has been great. Nevertheless, it’s what we try and do every day.

In a sense, we sort of knock the very procedure that has gotten us to where we are. Is that a fair statement, Charlie?

Charlie Munger:

Absolutely. And that has always worried me. I don’t like being an example of an activity where most people who try and follow it will get terrible results. And we try and avoid that by making these negative comments.

Warren Buffett:

We’d make negative comments anyway.

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