Not all growth is equal

Another great article from PSG :

"In our strive toward continual improvement, we unashamedly look for guidance and wisdom from some of the world’s leading investors and historians which can then be applied and adapted to our methodology of investing. In many cases one needs to look no further than the Sage of Omaha.




In his 2007 letter to shareholders, Mr. Buffett fondly writes about See’s Candy, a business that has managed to deliver excellent growth while requiring very little in the form of additional capital.



See’s Candy was acquired for $25m in 1972 and at the time had invested capital of $8m, generating $5m in pre-tax earnings, a 60% pre-tax return on capital.



Fast forward to 2007 and See’s made pre-tax profits of $82m while the capital required to run the business amounted to $40m. On a cumulative basis the business earned a total of $1.35bn in pre-tax profits over the years, while only requiring $32m in the form of additional capital. All of the $1.35bn earned, except for the $32m, was “up-streamed” to See’s owner, Berkshire Hathaway to be used at their discretion, mostly to buy and grow other attractive businesses.



In Buffett’s own words, “Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)” – Berkshire Shareholder Letter 2007



As an investor, the See’s example appears to be the holy grail of investing; only paying an additional $32m to receive $1.3bn in dividends!



Behind See’s success were its strong brand positioning, which afforded the company extraordinary pricing power, the fact that the product was sold for cash, eliminating debtors, and its short production and distribution cycle, which minimized cash tied up in stock.



However, as growing companies generally have significant working capital and fixed infrastructure investment requirements, according to Buffett the typical company (as shown in table 1) would spend $400m in additional capital to grow earnings from $5m to $82m. While each additional dollar of invested capital generated $42 pre-tax earnings for See’s, company B only made an additional $3.4 for each dollar invested.



Company B’s 20% return on invested capital in 2007 is certainly not to be sneezed at, but the example clearly demonstrates the value inherent in growth for a capital light business.

While there aren’t many See’s available in today’s market, the investment team at PSG Asset Management is on the continual lookout for and proud owner of companies with strong sustainable competitive advantages, that are able to show capital light growth. In most cases these companies have exceptional management teams that are aligned to shareholders and not shy to part with excess cash resources should available investment opportunities either not strengthen their existing moat or satisfy shareholders’ stringent return requirements, as after all, not all growth is equal. "


REF : Philipp Wörz



"The PSG Angle is an electronic newsletter of  PSG Asset Management. "