Buffett (1986): The concept of Owners Earnings and Maintainance Capex

We got to know the master's views on his textile business. Let us go a year further and try to discuss what the guru has to say in his 1986 letter to shareholders.

The letter, as usual, though did contain quite a bit of commentary on the company's major businesses, it also had general investment related wisdom. This time around the master chose to speak on himself and his partner's role. This is what he had to say:

"Charlie Munger, our Vice Chairman, and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. This hasn't been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary - if my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing."

"The second job Charlie and I must handle is the allocation of capital, which at Berkshire is a considerably more important challenge than at most companies. Three factors make that so - 

• we earn more money than average; 
• we retain all that we earn; and, 
• we are fortunate to have operations that, for the most part, require little incremental capital to remain competitive and to grow. 

Obviously, the future results of a business earning 23% annually and retaining it all are far more affected by today's capital allocations than are the results of a business earning 10% and distributing half of that to shareholders. If our retained earnings - and those of our major investees, GEICO and Capital Cities/ABC Inc. - are employed in an unproductive manner, the economics of Berkshire will deteriorate very quickly. In a company adding only, say 5% to net worth annually, capital-allocation decisions, though still important, will change the company's economics far more slowly."

The master's non-interference in the management of the businesses he owned is now almost legendary. But just like the companies he invested in, he made sure that the people he put in charge had outstanding track records. Once that was done, he would completely move out of their way and let them manage the business. Indeed, when a business with favorable economics is run by an exceptional manager, the last thing one would want to do is upset the applecart. Yet again, while the line of thinking is simple yet extremely effective, it must have stemmed from the master's own experience of managing the operations of the textile business of Berkshire Hathaway. Having been at the wheels for years, he must have realised how difficult it is to successfully run a business and deliver knock out performances year after year.

Berkshire Hathaway, from the time Buffett has been at the helm, has never paid dividends to shareholders. This is because the master has always felt that he would be able to find a better use of capital than paying out dividends. And find he did! The returns that the company has generated for its shareholders have vastly exceeded returns by any other American company. A very difficult task indeed, especially over a very long period of time. He is also very right in saying that a company that earns above average returns and retains all earnings is likely to see its economics deteriorate much faster than a company retaining only 5% if the retained capital is not put to good use. In the end, the honours should definitely go to the company that makes the most effective use of capital.

The master rounded off the 1986 letter by introducing a concept of owner earnings, the one he frequently uses to evaluate companies. It is nothing but

(a) reported earnings plus 

(b) depreciation, depletion, amortization, and certain other non-cash charges minus

(c) the average annual amount of capitalised expenditures for plant and equipment that the business needs to fully maintain its long-term competitive position and current volumes.

While owner earnings looks similar to cash flow after capex and working capital needs, it does not take into account capex and working capital investment required for generating more volumes but instead takes into account capex that is required to maintain just the steady state operations. In other words, what we call as the maintenance capex. Since inflationary pressures can make maintenance capex look very large, analysts who do not consider it are bound to overestimate the worth of the company. In fact, this is what he has to say on those who do not consider the all-important (c) item in their evaluations.

"All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c). Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all US corporations were to be offered simultaneously for sale through our leading investment bankers - and if the sales brochures describing them were to be believed - governmental projections of national plant and equipment spending would have to be slashed by 90%."

http://www.equitymaster.com/detail.asp?date=8/30/2007&story=3