The Warren Buffet Way: Buy Commodities?
How Buffets Definition of a "Better Business" Is Applied Historically, and its Radical Shift Underway Today
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.
Therefore, a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success…
It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements… - Berkshire Hathaway Annual Letter 2007
Buffet Better Businesses
The concept of a “better” business was brought to the mainstream with Warren Buffet’s conversations around moats in speeches and annual literature produced by Berkshire Hathaway.
Historically a business with a moat has a few key attributes which are high returns on capital stemming from barriers to entry in the industry itself, and from that dynamic comes pricing power, industry discipline and a host of other advantages.
When the average market participant thinks about what may classify as a moat and what businesses have staying power many will look to branded companies, staples in the economy that are critical to the day to day lives of the average American.
We would suggest that to only ascribe better business attributes to branded businesses is a mistake. Charlie Munger often cites the only reason Buffet and by extension Berkshires record was as good as it was is Buffets willingness to learn and adapt to a changing market environment.
That theme of changing economic landscape is the core motivation of this piece. If one is open to the idea that basic economic principles of supply and demand work, that high returns on capital no matter the industry will eventually attract too much capital and revert returns to the mean, then by extension one is explicitly or implicitly admitting that what is a better business can and does change over time.
What Has Been a Better Business
Since the Global Financial Crisis (GFC) the principles associated with better businesses has largely populated the tech sector. High margins, and pricing power from the handful of massive tech companies has drawn capital away from the tangible economy and into the intangible.
Returns on capital for these businesses have been impressive, revenues and earnings per share have exploded and the best of the group known as FAANG or more affectionately known today as the Magnificent 7 are where investors have flocked to for safety.
This is not to say tech companies have not performed exceptionally well and the adoption of the most cutting-edge tech is undeniable. When you look at rates of adoption Personal Computers took 20 years to reach 50% US household share, desktops 12 years, Mobile Internet 6 years and the new Artificial Intelligence (AI) driven by the likes of ChatGPT and other open-source platforms is estimated to take just 3 years to achieve 50% household adoption.
While it is easy to get caught up in the glamor of the tech industry broadly, was this not the same argument to be made for Radio in the 1920s, Semiconductors in the 1960s, and “dot coms” in the 1990s? Those were technologies that attracted a vast amount of investor capital and public interest but eventually the puck shifted elsewhere.
We would suggest that the tech businesses of today are moving toward a state of increased capital intensity due in large part to the need to scale data center infrastructure to meet AI demand which will include investments in the energy base to meet baseload power requirements - not to mention, where will the materials come from the build out that capacity?
If directionally we are correct on this theme, what was a better business might very well be changing before our eyes. Nvidia for example has a monopoly in the end market it serves in AI and has benefited greatly from first mover advantages in that particular arena. The Questions we would ask are is it likely they continue to control 90%+ market share in the Data Center/ GPU business over an extended period of time? It is reported that through 2030 the Data Center and GPU market will grow at a CAGR of 10-12% and trillions of fresh capital expenditure will enter the space through the same period.
We think the facts on the ground today point to more capital spending required, more competition and a deterioration of returns on capital as the capital cycle plays out in the space.
Returns on capital over the last 10 years in tech have been beyond exceptional. The total market on a normalized basis in the last 10 years has averaged 7.64% returns on capital. By contrasts Computer Services has achieved 37.5%, Computer Peripherals 54.44%, Semiconductors 19.92%, Semiconductor equipment 35.29%, and telecom equipment of 34.28%.
If we use basic economics as our guide these returns on capital will attract new entrants, capex will rise as limitations of scale are hit and new capacity is needed likely just in time for demand to disappoint and prices to decline for the base product.
Mckinsey estimates that through 2030 $6.7T of capital expenditure will be deployed in data center infrastructure - the question becomes, what is the return on those funds as competition increases and margins become stress tested?
What is a Better Business TODAY?
To reiterate, better business defined from the Oracle of Omaha himself are companies with barriers to entry and high returns on capital employed. We would suggest that businesses such as oil services, steel, lumber, natural gas, coal, chemicals, are all meeting this definition today, and certainly over the next decade.
Putting aside any preconceived notions of commodities and industrials broadly, lets chat about where these industries stand currently. The majority of the industries I listed and many that I did not have gone through a decade+ of poor returns. Those poor returns have led to capital moving away from these base industries and moving elsewhere - capital follows returns and manifesting cash flows.
Through the decade of poor performance many of the firms have gone through financial distress and either were purchased for pennies on the dollar, went bankrupt and have reemerged, reduce capacity to right size supply/demand and many companies in the industries we follow have done a combination of all of these things.
In addition, the competitors that remain in these industries did not survive by accident. The majority of the management teams that remain are prudent, shrewd operators who have been taking on water for a decade. We would suggest these are great management teams in many cases also checking Buffets box of aligning oneself with able operators and good capital allocators.
Management quality and industry consolidation lead to more industry discipline that leads to a longer “reaping” phase as the market recovers and rather than spending on supply additions they pay down their debt, buyback stock or further consolidate the market they are in which increases pricing power and extends the period of high returns.
Returns on capital are exceptionally high because as supply becomes tight and demand recovers all cash generated in excess of your fixed capital base falls to the bottom line thus, margins increase. For a thought exercise, think about a 7th Generation drill ship that Transocean (RIG) owns or a high spec OSV that Tidewater (TDW) own.
Outside of your sunk costs to operate the vessel to include the amortization of your 5-year SPS costs, given that there is no new building interest and you own the youngest, best fleet in your industry, these businesses cannot help themselves but generate supernormal returns on capital.
Not to mention, the barriers to entry in these businesses are exceptionally high. Who is going to go out and build a new plant to produce caustic soda or blast furnace steel here in the US? How about a new sawmill? The only way to enter these businesses is to buy in and when the time comes where acquisition is attractive to outsiders those businesses will be on the market for a premium to the value of their assets as returns and cash flows will be exceptional.
Concluding Thoughts
We put this piece together because it has taken a significant amount of our mind share over the last few years. What makes a better business comes from the basic principles of economics and we all know economic realities are ever changing.
Who is advantaged and what industries stand to benefit from those new economic realities present a tremendous investment opportunity for the next decade and the best part is, to buy these better businesses today you are paying 2-3x normalized cash flows with optionality from management allocation skill by using those cash flows to further consolidate industries and exploit their pricing power.
Invest accordingly.
