Friday, March 23, 2012

Investing In the Compounding Machine

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. 

– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter
The following exchange took place during the Q&A portion of the 2011 Berkshire-Hathaway Annual Meeting. It is paraphrased from this account provided by Ben Claremon of The Inoculated Investor blog.

QuestionThe only option for a shareholder nearing retirement to get income is to sell shares of Berkshire-Hathaway stock. This is because the company doesn’t pay a dividend, even though you like to collect dividends. So, when would you consider paying a dividend?

Warren BuffettCharlie and I will pay a dividend when we have lost the ability to invest a dollar in a way that creates more than a dollar in present value for the shareholders…Every dollar that has stayed with Berkshire has grown much more than it would have if it had been paid out as a dividend. As such, it is much more intelligent to leave a dollar in…There will come a time – and it may come soon – when we can’t lay out $15 billion a year and get back something that is worth more than that for shareholders. The stock will go down that day. And it should because paying a dividend means the compounding machine is dead.


Like all businesses, Amazon has decisions to make about what it does with its cash. There really are only a handful of choices: pay it out to investors (dividends, share buybacks, and debt pay-off), plow it back into the business (capital investment, expense investment, and acquisitions), or let the cash accumulate.

If Amazon management has good reason to believe that plow-back investments are likely to produce greater earnings power in the future - and by that I mean the returns on the investment are in excess of the cost of the capital, or what a reasonable investor might expect to earn on the cash if he were to deploy it outside of Amazon - then they should reinvest in the business. If they believe that the plow-backs will allow them to create a franchise with enduring competitive advantages, I would go so far as saying they have a fiduciary responsibility to continue reinvesting in the business.

Many value investors like companies that are quick to return cash to shareholders. I understand that. There's security to getting that cash out. It creates warm and fuzzy feelings, and it lets you deploy it for other purposes like consumption (that new iPad or the bracelet your wife wants) or alternative investments. 

Theoretically speaking, when businesses return cash to shareholders they're confessing to one of two things. 

One, that they can grow earnings without reinvesting more cash. They simply don't need the cash. These businesses are gems and equally as rare (or at least too pricey for value-minded investors to consider).

Two, that they cannot reinvest that cash in a way that produces satisfactory returns. They are running out of profitable growth opportunities. And in that case, returning cash to investors is the responsible thing to do. 

(I write "theoretically" at the outset because oftentimes managers return cash to shareholders irrespective of reinvestment opportunity because they have a history of paying out dividends and any change to that history will cause much consternation in the shareholder base. They don't want the stigma of being the managers who cut the dividend, ticked off legacy investors, created concerns - legitimate or not - about the business health, and caused a dip in the stock price.)

When we wish for the security of dividends, it usually means we're wishing the companies we have invested in have run out of markets for profitable reinvestment. It means we don't want them to grow as much as perhaps they could. It means we're welcoming the day the compounding machine died.

Should current owners of Amazon wish the company stopped its investments in...
  • subsidized shipping to pull more shoppers to the web and away from traditional retail?
  • lower prices on products and services to entice more consumers into utilizing Amazon and becoming repeat customers? 
  • content to encourage more customer loyalty via Amazon Prime membership?
  • increased fulfillment capacity in warehouses whose proximity guarantee faster delivery of an even wider selection of products?
  • software that makes buying easier, faster, and more secure?
  • devices like Kindles which encourage consumption of high margin digital media as well as increased shopping on
  • technical talent to extend market dominance over the burgeoning field of cloud computing?
  • more server and hardware infrastructure to attract more cloud computing customers?
  • little (expensive!) orange robots that will drastically reduce the company's dependence on (expensive!) manpower (and air conditioning) over time?
In business, as in life, there are always trade offs. If we want Amazon to show us more earnings now, or to share the cash with us, we must be willing to give up the long-term advantages created for the business by making the investments listed above. We must trade future earnings for immediate cash.

The question much do the investments above enhance the value of the business by allowing it to generate greater earnings in the future?

Quick answer: I don't know...but it's still worth thinking through some possible scenarios.

This post was originally published here on Adjacent Progression.