It’s no secret that Warren Buffett and Charlie Munger are one of the greatest investing duos of the last century. Over the years, they have produced endless knowledge through books, interviews, interviews, and yearly Berkshire Hathaway reports. But in 1994, Charlie Munger gave a famous talk at USC Business school on “A Lesson on Elementary Worldly Wisdom,” and there was one nugget in that speech that completely changed my way of looking at how well a business performs.
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Here’s What Charlie Munger Said
“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 a fine result.”
In other words, when investing for the long term, a business will return roughly what the business itself returns on its capital – this may be in the form of stock price increases or dividends. I decided to dig a little further into what this means.
Charlie is comparing the investment returns when buying and holding two different businesses for roughly 30-40 years. You may have heard Warren Buffett’s quote, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Fair vs. Wonderful Company Example
Let’s use this to describe these two businesses.
The Fair Company will earn 6% on its capital each year.
The Wonderful Company will earn 18% on its capital each year.
Both of these companies have capital – money invested – from their owners. And each business earns a return on that capital each year called earnings.
The difference between the Fair and Wonderful Company is the 6% and 18% earnings, respectively. The Wonderful Company can earn three times as much with the same capital. So how does this play out over time?
Let’s say they both start with $500K and both *reinvest* the profits.
After year 1, the Fair Company will have $500K, plus $30K in earnings. Now $530K in capital.
The Wonderful Company will have $500K plus $90K in earnings. Now $590K capital.
Here is a chart to show you the profound impact this had over 30 years.
The results are astonishing over 30 years. The Fair Company is earning $162.55K a year, whereas the Wonderful is earning $10.94M!
However, the pricing of the business is the second component. The purchase price multiple on the Wonderful Company must be higher than the Fair Company.
Charlie’s Magic
The investor’s purchase and sale prices don’t matter much over long periods. Regardless of the entry or exit price, the investor will ultimately receive more or less each year – the same as the underlying business. That means that even if an investor can purchase the Fair Company at a very good price/earnings ratio (low P/E ratio), the benefit of the low price will diminish over time. Conversely, if an investor pays the price of a high P/E multiple for the Wonderful Company, the high price of this purchase will also diminish over time. It will eventually return to 18% per year.
The Price to Earnings (P/E) ratio refers to a company’s current share price divided by how much the company earned per share (EPS – earnings per share).
For context: Tesla is currently 55. Microsoft is currently 29 (Mar 2023).
Let Me Demonstrate How This Works
The Fair Company sells for ‘cheap’ at a forward P/E of 7, and after 30 years, it sells for a P/E of 20. A forward P/E is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation.
Even though we got a ‘cheap’ purchase price and a 7x P/E multiple, the 30-year return is 9.78%
That’s the equivalent of $1 -> $16 over 30 years.
Now, we buy the Wonderful Company at an ‘expensive’ forward P/E of 45 and sell it 30 years later for a reduced P/E of 20.
Even though we paid a premium P/E and sold for a lower P/E, we still managed to earn 14.85%.
That’s the equivalent of $1 -> $64
That’s The Magic!
Over an extended period of 30+ years, the quality of the business, measured by its return on capital and how it’s reinvested, is far more important than market timing and price paid.
Keep This In Mind
High returns on capital are not the only parameter that will lead to such success. Scaling the capital into new investment opportunities to continue to scale the company can be challenging over time. Many companies will stall after 10-20 years and start issuing dividends or begin taking riskier endeavors. The results of these over time can have a large impact on the overall returns.
Here’s an example of a Wonderful business that, after 15 years, starts paying 50% of its earnings in a dividend rather than reinvesting. The difference in the long term growth of capital is significantly stalled, and it’s very easy to mistake the dividend paying business for a Wonderful business. This isn’t to say that all dividend businesses are not Wonderful. See the chart below to see how it compares.
Munger acknowledges that having a great management team can greatly impact this outcome. He says, “an occasional opportunity to get into a wonderful business run by a wonderful manager. And, of course, that’s hog heaven day.”
Conclusion
The main thing to understand here is that timing and price are not as important as the long-term return on the capital. Adequate research and understanding of the business fundamentals will reinforce your conviction. Many people get caught up trying to buy a company for a lower price by following the day-to-day price action. In reality, the thing to consider is even if you feel you’re paying above market rate for a company, and it’s truly a Wonderful business, it will work out in the long run.
Warren Buffett is one of the most successful investors in history, and his sage advice has helped countless people to grow their wealth. Here’s one of my favorite quotes from him:
