Great Companies Reinvest

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Great Companies Reinvest

Introducing the Ideal Company Type

INTRO

It seems the vast majority of people don’t understand that building wealth takes time. The other side of that coin is the fact that once wealth has been attained, losing it can happen in an instant. That's why handling money requires caution.

Reference this article by Beanstox, which highlights the fact that true wealth lies in "the long game." As it states, it is in the long-term where the true marvel of compounding shines brightest, transforming modest gains into real wealth.

As such, choosing the right companies to invest in is crucial. You might think, "I need to be a genius for that." Not true at all.

I always remember this legendary quote:

          "You don't have to be brilliant, just a little bit wiser than the other guys, on average, for a long, long time." – Charlie Munger

Just as managing money on a personal level requires caution, it's also imperative for companies to do the same when it comes to managing capital. Let me show you how to find the ideal company to invest in. And it’s all connected to a long-term mindset.

Let The Winners Roll

As is the case with most kids, I loved candy when I was young. I had a strong craving for candy—something that provided instant gratification with no patience for delays. Unfortunately, many people still operate this way even well into adulthood.

• Want a new car? They buy it next week.

• Dream house out of budget? No worries, they’ll figure it out.

• Instant 100% returns on investment? That's where reality hits, as sustained, rapid gains are rare.

Unfortunately, humans have an innate desire for instant gratification, which is the urge to want good things right away. This desire is rooted in survival, as our ancestors needed to make immediate decisions to benefit themselves in the present.

This is where the need for a so called “delayed gratification” kicks in from an investment perspective. You need to be strong enough to sustain your urges and hold the winners for the long-term because true wealth is built slowly. Now, I want you to really imprint this next sentence into your brain.

Let the winners roll. Why? Businesses, if well-managed, can utilize earnings better than most investors can, either by reinvesting them in the business or by repurchasing their own shares. So, by cashing out you’re only missing out on potential future gains.

Now, without further delay, here is the ideal company.

The Ideal Company

Let me be clear: the perfect company doesn’t exist. However, you can get remarkably close so we'll refer to that as the ideal company.

Here are three key traits of an exceptional company.

Firstly, a strong and durable competitive advantage ensures it can sustain profitability and fend off temporary bad news and the competition in the long term.

Secondly, these companies consistently reinvest profits into innovation, expansion, or enhancing their core strengths, ensuring sustainable growth and shareholder value, while also mitigating unnecessary expenses.

Lastly, being an industry leader allows these firms to dictate market trends, command premium pricing, and attract top talent and investment.

Here are a few examples:

• Apple Inc. (AAPL) - known for its innovative products and brand loyalty.

• Amazon.com, Inc. (AMZN) - dominates e-commerce and cloud computing with continuous reinvestment in technology and infrastructure.

• Microsoft Corporation (MSFT) - a leader in software and cloud services, focusing on innovation and acquisitions.

• Alphabet Inc. (GOOGL) - the parent company of Google, a leader in online search, advertising, and technology.

As I've emphasized continuously, aim to identify companies with excellent business economics selling at attractive prices for investment opportunities. With such companies, the retained earnings of the business will continuously increase the underlying value of the business and the market will ultimately increase the price of the companies' stock.

The key exists within Management's ability to properly allocate capital and keep adding to the company's net worth. Within your investment analysis of any potential buying opportunity, be sure to review a company's historical increase or decrease in the price of its shares, along with the historical increase or decrease in the company's per share book value. Make an assessment over an extended period, typically about 10 years back. A company with a clear durable competitive advantage will have both an increasing book value and an increasing share price.

Using Seeking Alpha Premium, you can readily assess the 10-year stock price and Retained Earnings picture (go to "Financials" then "Balance Sheet") of a company.

The One Dollar Rule

In any given year, prices of a stock can fluctuate quite significantly for reasons other than value. Warren Buffett uses The One Dollar Rule as a quick test to gauge Management's effectiveness at utilizing a prospective company's retained earnings.

Over time, an increase in value should, at the very least, match the amount of retained earnings dollar for dollar. Of course, if the value goes up in excess of the level of retained earnings, that's even better. But, as a whole, each dollar of retained earnings should essentially translate into at least a dollar of market value.

As an example, in April 2021, Apple committed $430 Billion in investments over the next 5 years. At the time, Apple's market valuation was $2.24Trillion. Utilizing the one dollar rule as a test of management's effectiveness in reinvesting this $430 Billion of capital, we would expect an increase in the market value of the company of at least the same amount by 2025 ($2.24 Trillion + $430 Billion would be $2.67 Trillion).

Well, the year 2025 hasn't even arrived yet, but Apple's market value has already surpassed $3 Trillion and is currently hovering at about $3.6 Trillion, reflecting a huge increase in shareholder value since that reinvestment commitment.

Using our investment tool Tykr, we can also readily assess Management's effectiveness in deploying capital for Apple. Apple exhibits high profit margins but also, importantly, high levels of return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC) - all at levels that well-exceed industry averages.

This is why an assessment of a company's Management is also critical. The most important management act is the allocation of a company's capital, which will ultimately determine shareholder value.  

And as Buffett emphasizes, deciding what to do with a company's earnings – reinvest in the business or return capital to shareholders via dividends or share repurchases – is an exercise in logic and rationality. We want to invest in companies with logical and rational managements.

If retained earnings can produce an above-average return on equity (ROE), then the company should retain all of its earnings and reinvest them. Otherwise, the company should distribute excess cash to shareholders via dividends or share repurchases.

Stay Away From These Companies!

Before we wrap up, take a look at this chart, which shows the difference between reinvesting profits (Alphabet) and cashing them out (Cisco).

Ideally, you'll want to invest in companies that can redeploy earnings at above-average returns to ultimately increase shareholder value. In the case of Cisco, clearly too much of its earnings are being paid out as dividends to shareholders. As pointed out by Simply Wall St, while Cisco does earn a fairly high rate of return (ROE) on the earnings it does reinvest, growth has likely been hampered from reinvesting only a small portion of those earnings and instead paying them out as dividends.

No need for further elaboration—the lesson is clear. Where the ability to reinvest at above-average returns exists, it's necessary to do so. ‍

Reinvesting is critical both in life and investing.

Conclusion

Companies with durable competitive advantages - the type in which you should be aiming to invest - are better able to retain earnings with more effectiveness and flexibility to utilize them in ways that generate value: expanding market share, increasing earnings, buying back shares, etc.

In turn, the ultimate result is reflected in increasing stock prices, thereby making shareholders wealthier.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

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