Using 2 Examples To Illustrate Buffett's Compounding Concept

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Includes: ANZBY, WFC
by: Zejia Yao

The idea of compounding is the cornerstone of Warren Buffett's investment philosophy. It was referred to in his shareholders' letters several times either explicitly or implicitly. The fundamental objective Buffett wants to achieve in running the company is to compound his funds at a better-than-average rate of return with less exposure to long-term loss of capital (Warren Buffett's 1962 letter to partners). Buffett practices what he preaches. From 1965 to 2013, Berkshire's per-share book value has grown at a compounded annual rate of 19.7%. For the same period, Berkshire A-share's share price has multiplied from $18 to $177,900, a CAGR of 21%, which is 11.3% above the market performance of the S&P 500. The fact that Berkshire can achieve such stunning wealth accumulation is, to large extent, attributed to the application of the value compounding concept by Buffett and Munger in their stock selection process.

In this article, I would like to use two real examples to illustrate the compounding effect (i.e. how a higher "compounding" company will bring higher shareholder returns).

To start with, we have to understand what drives the growth of a company's book value (intrinsic value). Think about how a business runs: Shareholders and creditors give the company capital (the former is equity and the latter is debt). The company uses the capital to buy property, plant and equipment and other operating necessities, including hiring personnel. Then the company generates revenue. Using the proceeds, the company pays its expenditures, including sales, general and administrative expenses. The company also pays interest to creditors for debt and taxes to the government. The balance, which is called net income, is the return to shareholders. Now the company may pay a portion of the net income to shareholders as dividends and keep the remaining to reinvest in the company. The retained earnings will also be used to purchase additional PPEs or hire more staff to sustain growth. As the cycle repeats, the company grows. Therefore, the company's growth depends on how much net income is generated and what proportion can be retained and reinvested. Put it into a formula, the sustainable growth rate, and you get what Buffett referred to as the "compounding" rate, or, the rate of return on shareholders' equity times the earnings retention rate (ROE*retention rate).

As we can see from the formula, the higher the ROE, or the greater percentage of the earnings that can be reinvested to the company, the higher the compounding growth rate. To demonstrate this correlation, I will use two companies from the banking sector to compare (I read a post from a blogger who uses Wells Fargo as an example to illustrate "book value compounding" and here, I would like to pick another banking stock for comparison to further elaborate on the point). The two companies I choose are Australian and New Zealand Banking Group (ANZBY) from the Australian Stock Exchange and Wells Fargo (WFC) from the New York Stock Exchange.

The period I chose for this study is from 1987 to 2014.

Let's first look at ANZ. According to the below table, ANZ's book value has been compounded at 4.2% from 1987 to 2014.

Table 1 ANZ book value growth

Sep-87 Sep-14 CAGR
Book Value per share 5.48 16.72 4.2%

The book value's CAGR has driven an average return on equity of 12.5% and 36.3% of the earnings retained to reinvest. The year-to-year data is in the below table.

Table 2 ANZ's ROE, retention rate and growth rate from 1987 to 2014

ROE Retention Rate Growth rate ROE Retention Rate Growth rate
1987 13.1% 62.6% 8.2% 2001 18% 37.8% 6.7%
1988 15.1% 51.2% 7.7% 2002 20% 42.3% 8.6%
1989 17.2% 51.0% 8.8% 2003 17% 49.4% 8.4%
1990 10.0% 20.1% 2.0% 2004 17% 34.03% 5.8%
1991 5.8% 27.8% 1.6% 2005 32.60% 35.10% 11.4%
1992 -13% 100.0% -12.6% 2006 17.10% 37.50% 6.4%
1993 5% -48.1% -2.3% 2007 15.60% 39.31% 6.1%
1994 15% 55.3% 8.3% 2008 -33.50% 20.19% -6.8%
1995 18% 52.8% 9.7% 2009 9% 17.70% 1.6%
1996 18% 45.0% 7.9% 2010 13% 28.40% 3.7%
1997 15% 30.0% 4.4% 2011 14% 31.40% 4.4%
1998 13% 28.4% 3.7% 2012 14% 30.60% 4.2%
1999 16% 38.2% 6.0% 2013 14% 28.20% 3.9%
2000 18% 40.1% 7.1% 2014 16% 31.40% 5.0%
Average 12.5% 36.3% 4.6%

Source: ANZ 1987-2014 Annual Financial Report

Note the difference between the CAGR of 4.2% in Table 1 and rough year-by-year calculation of the book value growth of 4.6% in Table 2. The difference is a result of a number of factors, such as share issuance/buyback, dividend reinvestment, etc.

For the same period, ANZ's share price has grown at a CAGR of 7% from $5.02 in September 1987 to $30.92 in September 2014.

Let's turn to Wells Fargo. Wells Fargo's book value has been compounded at 11.7% from 1987 to 2014 (adjusted for stock split).

Table 3 WFC book value growth

Dec-87 Sep-14 CAGR
Book Value per share 1.46 31.05 11.7%

The compounded value growth is driven by an average ROE of 15% and an earning's retention rate of 59%. Year-by-year data is in table 4.

Table 4 WFC's ROE, retention rate and growth rate from 1987 to 2014

ROE Retention Rate Growth rate ROE Retention Rate Growth rate
1987 2% 0% 0% 2001 15% 57% 9%
1988 24% 75% 18% 2002 20% 67% 13%
1989 25% 71% 18% 2003 19% 59% 11%
1990 25% 72% 18% 2004 20% 55% 11%
1991 0% 0% 0% 2005 20% 56% 11%
1992 7% 66% 5% 2006 20% 57% 11%
1993 17% 78% 13% 2007 17% 51% 9%
1994 22% 73% 16% 2008 5% 0% 0%
1995 30% 77% 23% 2009 10% 72% 7%
1996 9% 57% 5% 2010 10% 91% 9%
1997 13% 59% 8% 2011 12% 83% 10%
1998 10% 40% 4% 2012 13% 74% 10%
1999 18% 65% 12% 2013 14% 71% 10%
2000 16% 61% 10% 09/2014 14% 69% 10%
Average 15% 59% 10%

Source: Wells Fargo 1987 to 2014 annual reports

From 1987 to 2014, Wells Fargo's share price has increased from $1.57 to $51.87, a CAGR of 13.4%.

Put the two companies' data into one table to compare, we can see that Wells Fargo's book value has compounded at a faster rate than ANZ and therefore it brought greater shareholder return (purely share price appreciation).

Table 5 ANZ vs WFC

Book value compounding rate Share price appreciation Dividend yield Total return
ANZ.ASX 4.20% 7% 5.70% 12.70%
WFC.NYSX 11.20% 13.40% 2.50% 15.90%

If considering the dividends, we see that ANZ had a higher dividend yield than Wells Fargo, partially because ANZ has higher payout rate than Wells Fargo (63.5% vs 41%). Therefore, the shareholders' total return for ANZ is 12.7% and for Wells Fargo, it's 15.9%. Still, Wells Fargo offered a better return.

The above analysis is purely a quantitative analysis, focusing on book value compounding. It doesn't means that Wells Fargo is a better investment than ANZ, as a number of other aspects, such as the regulatory environment in the two countries, the financial health of the two companies, etc. are not taken into consideration. For example, ANZ's financial leverage is much lower than Wells Fargo-- ANZ bank group has barely any long term debt. The debt-to-equity ratio for ANZ is roughly 0.15 whereas it is 1.04 for Wells Fargo. Therefore, we can say that higher ROE for Wells Fargo is partly driven by the higher financial leverage. If we take into account both debt capital and equity capital (i.e. considering the return on total capital employed (ROIC)), ANZ provides a better return than Wells Fargo.

Besides, from the above comparison, some investors may think that the higher retention rate, the better investment return (assuming investors focus on the capital gain only as capital gain as a result of share price appreciation) gives investors a better after tax return than dividends. However, this is not always the case. Investors should bear in mind that only if the company has better reinvestment opportunities (i.e. reinvesting the earnings will generate a higher return to shareholders than distributing the earnings to shareholders), can we say that a higher retention rate is better. If there isn't any good business growth opportunity and the companies still keep the earnings, it will, instead, dwarf shareholders' investment return as shareholders will be better off if they take the earnings as dividends and find other investment opportunities.

To sum up, we looked into two real examples to illustrate Buffett's book value compounding concept. As we can see, companies with higher compounding rates will generate higher returns to shareholders. The compounding rate is determined by how efficient the company employs shareholder capital (ROE) and the percentage of earnings that the company can retain and reinvest. Investors should bear in mind that the purpose of this analysis is to illustrate the correlation between book value compounding and shareholders' return. When making stock investment decisions, investors should consider other quantitative and qualitative factors.

Disclosure: None.

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