Economic Goodwill and your business eye - what do you decide?

[anders]

As you well already know, a company is logically more valuable than its net assets if it can produce a return on those assets above current market rates.

The created value on that return over market rates, I define as economic goodwill. Or from another perspective, how much reinvestment the company needs to increase its return on capital.

 

So, we have two equally good businesses:

Company A earns 2m on 8m assets and cost 25m (8% EY) to buy.

Company B earns 2m on 18m assets and cost 18m (11% EY) to buy.

 

Under a normal economic environment, Gramham-followers would probably choose Company B and Buffett-followers go for Company A.

 

But we are not in a normal economic environment, we are in a inflationary (ie FEDs $85bn/month programme), deleveraging environment (similar to post world war II) something very few investors have experienced in real life, so my question comes down to this:

 

With currently low inflation, deleveraging economy and, history low interest environment, what company above do you decide to buy and what is the reasoning behind it?

 

 

Best Regards,

 

[JBird]

I am really impressed with this question.

 

I pick A because of its advantage in years of inflation. I also think that the returns are sensible under current interest rates.

[racemize]

I pick A because of its advantage in years of inflation.

 

I think there's a good Buffett explanation on that (I guess from the 70s)--or perhaps it was focused on the advantages of non-capital intensive businesses in periods of inflation?  I think the same reasoning applies though.

[zarley]

Which one has pricing power and more predictable future prospects?

[mcliu]

Isn't Company A a no-brainer given the much higher ROE?

[JBird]

Isn't Company A a no-brainer given the much higher ROE?

 

The answer is no, and that's only because he put a higher price tag on A. If you knew for certain there's no high inflationary years ahead, it makes sense to go with B- your annual return is plainly higher

[savant]

Depends on what rates the companies can continue reinvesting.

 

I would think that if A can continue to reinvest at the higher ROE for a longer period then it is the better business/buy irrespective of the macro given the difference in multiples.

[LC]

Now might be the time to invest in a capital heavy project: at least that is what the Fed wants us to do via their policies. How often can companies access debt at such low rates?

 

How does deleveraging play into this equation?

[Guest deepValue]

Company A, hands down, in any environment. As a long-term holding, A will compound your money at a rate so much higher than Company B that a decade later you'd wonder why you ever considered the three percentage point difference in initial yield to be worth contemplating.

 

Of course, this assumes that Company A can and does re-invest its cash flow at 25%.

[JBird]

Company A, hands down, in any environment. As a long-term holding, A will compound your money at a rate so much higher than Company B that a decade later you'd wonder why you ever considered the three percentage point difference in initial yield to be worth contemplating.

 

Of course, this assumes that Company A can and does re-invest its cash flow at 25%.

 

Of course you're absolutely right. I didn't consider reinvestment because it wasn't raised as consideration in Ander's original post.

[Otsog]

It is a sobering thought that you could have lost money investing in Coke over a decade long holding despite consistent profit growth over that period.

 

Also, hypothetical companies are not in my circle of competence.

 

Option c: put the money under my mattress

[wachtwoord]

I am really impressed with this question.

 

I pick A because of its advantage in years of inflation. I also think that the returns are sensible under current interest rates.

 

Could you explain the advantage of A in years of inflation specifically?

[JBird]

I am really impressed with this question.

 

I pick A because of its advantage in years of inflation. I also think that the returns are sensible under current interest rates.

 

Could you explain the advantage of A in years of inflation specifically?

 

I would but Buffett does a better job than I could; check out the 1983 Berkshire Annual report. At the end he attaches an appendix called Goodwill and its Amortization: Rules and Realities. It is a financial masterpiece.

[oldye]

company A sure sounds a lot like see's candy  ::)

[Guest deepValue]

Company A, hands down, in any environment. As a long-term holding, A will compound your money at a rate so much higher than Company B that a decade later you'd wonder why you ever considered the three percentage point difference in initial yield to be worth contemplating.

 

Of course, this assumes that Company A can and does re-invest its cash flow at 25%.

 

Of course you're absolutely right. I didn't consider reinvestment because it wasn't raised as consideration in Ander's original post.

 

I'm biased toward great businesses and against cigar butts, so I have no qualms about bending a hypothetical to suit my sensibilities.

[twacowfca]

Isn't Company A a no-brainer given the much higher ROE?

 

The answer is no, and that's only because he put a higher price tag on A. If you knew for certain there's no high inflationary years ahead, it makes sense to go with B- your annual return is plainly higher

 

Or is it?  Considering the cost of capital (8%?  9%?) for a small company, A is the clear choice, ceteris paribus, given the information supplied.  Interestingly, A would likely have a lower cost of capital than B because of its superior economics.  A Bayesian analysis with weighted probabilities for various stress tests, including inflation, would almost certainly show A to be more anti fragile, assuming that the two companies are comparable, except for the superior economics of A, compared to B.  :)

[ericd1]

Isn't Company A a no-brainer given the much higher ROE?

 

The answer is no, and that's only because he put a higher price tag on A. If you knew for certain there's no high inflationary years ahead, it makes sense to go with B- your annual return is plainly higher

 

Or is it?  Considering the cost of capital (8%?  9%?) for a small company, A is the clear choice, ceteris paribus, given the information supplied.  Interestingly, A would likely have a lower cost of capital than B, ceteris paribus, because of its superior economics.  A Bayesian analysis with weighted probabilities for various stress tests, including inflation, would almost certainly show A to be more anti fragile, assuming that the two companies are comparable, except for the superior economics of A, compared to B.  :)

 

Huh???

[wachtwoord]

I am really impressed with this question.

 

I pick A because of its advantage in years of inflation. I also think that the returns are sensible under current interest rates.

 

Could you explain the advantage of A in years of inflation specifically?

 

I would but Buffett does a better job than I could; check out the 1983 Berkshire Annual report. At the end he attaches an appendix called Goodwill and its Amortization: Rules and Realities. It is a financial masterpiece.

 

Okay thanks I'll do that :)

[anders]

Thx all for great input!

 

Yes, this question derives from BRK letter 1983. But as munger recently said: "just because buffett said something 20 years ago doensnt make it an eternal law".

 

Me too would go for Company A, but Im not so sure with our current economic environment. Would it have been the best choice in Japan 1983 going forward?

 

Lets add reinvestment into the equation, that is under current market environment and we dont know the future rate of return.

 

Inflation is currently running at a negative rate and who knows the future of inflation? Which law states it cant run at a negative rate many years to come? (though In my opinion with current stimulans programs spread around the world its highly unlikely). Further on, we are in a deleveraging process (regardless of centralbank balance sheet expansion) which as you know put pressure on ROE in regards to margins and capital structure. Also, when the historically low interest rates normalises it will put pressure on ROE.

 

Some wrote that in a longterm perspective company A would be the best choice, I agree. But considering the arguments above, what then would be the probability that your investment lost purchasing power of the holding period (your Risk) compared to company B and, what would be the opportunity cost? Could this be a reason that Buffett is willing to accept more capital intensive businesses ie utilities and the purchase of BNSF that probably under these circumstances will provide a higher margin of safety inside the business?

 

At its core, could our current economic environment potentially twist or harm your transferred purchasing power into a high ROE vehicle such as Company A, to a degree that it will not deliver the expected purchasing power - after taxes have been paid on nominal gains - in the future and, as a corollary, would you then be better off or worse with Company B as an investment?

 

I realize its diffcult to discuss this without knowing the characteristics of the companies. Im just throwing up the ball here because my best decisions always come when I get input from all perspectives.

 

Best Regards,

 

[TwoCitiesCapital]

Thx all for great input!

 

Yes, this question derives from BRK letter 1983. But as munger recently said: "just because buffett said something 20 years ago doensnt make it an eternal law".

 

Me too would go for Company A, but Im not so sure with our current economic environment. Would it have been the best choice in Japan 1983 going forward?

 

Lets add reinvestment into the equation, that is under current market environment and we dont know the future rate of return.

 

Inflation is currently running at a negative rate and who knows the future of inflation? Which law states it cant run at a negative rate many years to come? (though In my opinion with current stimulans programs spread around the world its highly unlikely). Further on, we are in a deleveraging process (regardless of centralbank balance sheet expansion) which as you know put pressure on ROE in regards to margins and capital structure. Also, when the historically low interest rates normalises it will put pressure on ROE.

 

Some wrote that in a longterm perspective company A would be the best choice, I agree. But considering the arguments above, what then would be the probability that your investment lost purchasing power of the holding period (your Risk) compared to company B and, what would be the opportunity cost? Could this be a reason that Buffett is willing to accept more capital intensive businesses ie utilities and the purchase of BNSF that probably under these circumstances will provide a higher margin of safety inside the business?

 

At its core, could our current economic environment potentially twist or harm your transferred purchasing power into a high ROE vehicle such as Company A, to a degree that it will not deliver the expected purchasing power - after taxes have been paid on nominal gains - in the future and, as a corollary, would you then be better off or worse with Company B as an investment?

 

I realize its diffcult to discuss this without knowing the characteristics of the companies. Im just throwing up the ball here because my best decisions always come when I get input from all perspectives.

 

Best Regards,

 

In an environment with low interest rates,  companies that aren't capital intensive will be undervalued and companies that are capital intensive will be overvalued. This is simply because a company that can generate tons of cash on a small asset base has less of advantage if companies who can't can cheaply lever up to achieve the same results. If your paying 0%, you could borrow all the money you needed to operate and the ability to generate it internally isn't very valuable.... until interest rates rise. If you think rates will be low for a long time,then the company with a higher return on equity may not receive the premium valuation it deserves until rates move higher giving it a clear competitive advantage.

[constructive]

I'd buy company A. But at around $15 per B share I'd buy both and $10 per B share I'd only buy B.

 

A will primary generate internal gains, while B will primarily generate external gains, followed by your own reinvestment. It seems more unpredictable, therefore a discount is required.

[Kraven]

I'd buy neither. I prefer to invest in real, not hypothetical, companies. Even in the land of the hypothetical there is not enough info here to make any kind of decision. To say that a certain kind of investor would buy one over the other does a disservice to the investing process.

[netnet]

I have to (partially) agree with Kraven here. There is not enough information to make a decision. Now with more info then you can make a more considered judgement and then considering hypothetical companies is useful to improve thinking.

 

• What are the growth prospects?
  
• How do the competitive situations of the companies compare?
  
• How do the managements compare?
  
• Are these normalized earnings? Or how do they vary?
  
• Are these the owner earnings?  What is the real cash flow?
  
• etc. etc.
  

 

you get the picture; you need more information.  If B has vastly greater investment opportunities or has such a large and widening moat, i.e. a superior competitive position to A, then B is absolutely the way to go.

[JBird]

I'd buy neither. I prefer to invest in real, not hypothetical, companies. Even in the land of the hypothetical there is not enough info here to make any kind of decision. To say that a certain kind of investor would buy one over the other does a disservice to the investing process.

 

The point is well taken, and basically I agree. The purpose of the board though is to learn, and it seems this thread created an opportunity for at least one member to learn something new about inflation. To somewhat slam a post born out of intellectual curiosity is a disservice to the learning process.

[LC]

I'm not sure if it's been mentioned, but we also have to consider the competitive advantages of the two firms. Company A might be able to generate higher cash flows given the low capex, but if it turns out to be a tech company that will go out of business in 3 years, then the potential return on capital over the next 20 years doesn't really matter.

 

So I'd invest in whichever company has a better "moat" :)