Illuminating Reinvestment

Reinvestment opportunities are often lacking for value stocks — A business’s ability to reinvest is critical to its long-term performance — Combining price and reinvestment potential is a recipe for compounding.

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ILLUMINATING REINVESTMENT (Reinvestment Part III)

Reinvestment opportunity is often the missing piece for value investors. Blinded by the allure of dividends and share buybacks, value investors miss the opportunity to own businesses capable of generating attractive reinvestment returns.

As Charlie Munger pointed out in 1994, “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 one hell of a result.”(1)

But reinvestment opportunities are scarce. While businesses aim to invest at double-digit rates, most equity returns remain in the single digits. The world is messy, after all, and translating Excel projections into real dollars is challenging. Write-downs and impairments follow poor internal investments and M&A, eroding reinvestment returns.

Discovering Reinvestment

Active equity investors are often criticized for attempting to predict an unpredictable future. While macroeconomic and geopolitical events may be unknowable, company-specific investment opportunities are available for due diligence.

Reinvestment opportunities cannot be quantitatively screened for. Businesses with high ROE offer no guarantee that the next dollar invested will be at or above their historical performance. Once financials are published, they are already dated.

Investors must think creatively to assess the reinvestment projects available to a business and their true return potential. Settling for dividends and share buybacks of fairly valued businesses does not meet this hurdle.

Warren’s Approach

Warren Buffett recognized the importance of reinvestment. At Berkshire Hathaway, Buffett made reinvestment his sole focus, delegating nearly all other responsibilities to remain free of distractions. This highly focused approach is unique among CEO roles. 

Warren Buffett and Berkshire Hathaway did not achieve their track record by reinvesting at single-digit rates. While Buffett has never disclosed his hurdle rate, it is clear that Berkshire’s calculated WACC has no bearing on his target. It is reasonable to assume Berkshire’s investment hurdle rate is absolute, invariant to economic conditions, and at least double digits.

But having an investment genius solely dedicated to attractive reinvestment is only half the Berkshire story. The true magic of Berkshire is Buffett forcing every business under his control returns nearly all of its capital to Omaha. Too many businesses allow capital to be squandered by individuals untrained in reinvestment, preventing it from being put to its highest and best use.

 The Active Imperative

Active equity managers, in the private or public markets, can emulate Warren Buffett by upstreaming dividends and reinvesting strategically. By actively monitoring portfolios, managers can redirect dividends from businesses lacking reinvestment opportunities to those with attractive projects.

Whether by selecting businesses and management teams capable of reinvesting profitably or by directly controlling reinvestment decisions (as in private equity or activist management), active equity management creates value via reinvestment.

For active managers, the reinvestment conundrum is an opportunity. Identifying the few businesses with strong reinvestment potential, and acquiring them at value prices, offers a path to outperform indices hindered by subpar reinvestment.

The Missing Piece

Reinvestment is often overlooked in stock pitches. Analysts may praise historical capital allocation decisions that have little bearing on future reinvestment opportunity. Share buybacks are celebrated as reinvestment, yet their value is questionable unless a business trades at a low multiple. Dividends provide comfort to value investors but must be reinvested elsewhere.

Occasionally, businesses trade at value prices despite their ability to reinvest at high returns. Such opportunities often arise when macroeconomic or market conditions obscure a business’s long-term reinvestment potential.

This is where value investors must act to outperform. Combining a value price with reinvestment driven long-term growth is the recipe for truly spectacular compounding.

(1) Charles T. Munger, “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business,” USC Marshall School of Business, 1994, in Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger.