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Markel Corporation (NYSE:MKL), which has a long-term record of compounding capital at a high rate of return under the investment leadership of Tom Gayner and Steve Markel, has a four part equity investment philosophy. They seek,

To invest: 1) in common equity of profitable businesses with good returns on capital, 2) with honest and talented management teams, 3) with reinvestment opportunities and capital discipline, 4) at fair prices.

I want to focus today on the third part of Markel’s philosophy. Businesses that can reinvest their capital at high rates of return can generate tremendous wealth over time. They’re the mathematical equivalent of finding a savings account that pays 15-20% interest where you can reinvest your earnings at that same high rate of return for the next ten to twenty years.

Many otherwise very good businesses that throw off a lot of cash – See’s Candies, Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), etc. – reach a point where they are not able to find places to allocate their capital at a high rate of return. For See’s, it was the inability to expand the concept much beyond its core base in California, where it enjoys unusually strong share of mind built up over decades of superior execution. For businesses like Google and Microsoft, their core businesses throw off far more cash than is needed in those business units, and their managements have yet to find an answer for their growing cash balances.

This is less of a problem if you control the business, because you can take the excess cash and intelligently redeploy it. This is precisely what Buffett did with the excess earnings of See’s. With partial ownership of public companies, you are at the mercy of management’s capital allocation decisions. This is another reason to carefully evaluate the management team of a potential investment.

One of the best examples of a business with reinvestment opportunities I’ve come across is Buffett’s example of Thompson Newspapers from a speech Buffett gave at the University of Notre Dame in 1991.

Thomson Newspapers, which most of you have probably never heard of, actually owns about 5% of the newspapers in the United States. But they’re all small ones. And, as I said, it has no MBAs, no stock options – still doesn’t – and it made its owner, Lord Thompson. He wasn’t Lord Thompson when he started – he started with 1,500 bucks in North Bay, Ontario buying a little radio station but, when he got to be one of the five richest men, he became Lord Thompson. I met him one time in England as a matter of fact, in 1972, and went up to see him. He’d never heard of me, but he was a very important guy. (I’d heard of him!)

I said, “Lord Thompson, you own the newspaper in Council Bluffs, Iowa. Council Bluffs is right across the river from Omaha, where I live, four or five miles from my house. I said, “Lord Thompson, You own the Council Bluffs [Daily Nonpareil?]. I don’t suppose you’d ever think of selling it?” He said “I wouldn’t think of it.”

Lord Thompson, once he bought the paper in Council Bluffs, never put another dime in. They just mailed money every year. And as they got more money, he bought more newspapers. And, in fact, he said it was going to say on his tombstone that he bought newspapers in order to make more money in order to buy more newspapers [and so on].

So, where do you find businesses like that? The answer lies in 1) knowing what you’re looking for, 2) having a great search strategy, and 3) working that strategy hard on a consistent basis.

One type of business that has ample reinvestment options at high rates of return is an insurance company run by a great capital allocator, such as Berkshire Hathaway (Warren Buffett), Fairfax Financial (Prem Watsa), Markel (Tom Gayner), or Greenlight Capital Re (David Einhorn). These businesses have both a go-anywhere investment philosophy coupled with a disciplined investment process.

Very few businesses can continue to allocate capital the way these companies can. Moreover, because many CEO’s lack the skill to allocate capital outside their core business, moving beyond their circle of competency may actually destroy value.

The takeaway is to learn to identify these types of businesses and to consciously look for them as you execute your search strategy. You don’t need many of these to get rich.

Disclosure: Long GLRE, BRK.A, MKL, OTCQB:FRFHF

Source: The Ability to Reinvest Capital: Investments That Generate Wealth