If you are the guy who taught Warren Buffett how to appreciate quality investments, then you must have some serious investing wisdom. The great investor and thinker Charlie Munger left us with plenty of great insights. Today we unpack his encapsulation of Quality Investing:
“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.”
— Charlie Munger
Charlie is not describing the personalities of a management team, the details of a particular business model, or how to predict short-term market trends. Instead, he is giving us a simple, yet powerful, framework for beating the market over the long run.
💰 How Quality Creates Value
In 📖 “Stop Checking The Price!” we learned about the most important quality metric for a company: ROIC — the Return On Invested Capital. When ROIC is high, steady, and (ideally) increasing well above the WACC (Weighted Average Cost of Capital), the company is creating long-term value. Over the long run, this value creation beats the market.
Let’s unpack the deep insight behind Charlie Munger’s wisdom. Here is a table showing the fair market value (price-to-book) of $1 in the company for different ROIC sustained over 5 years. In other words, how should we value the capital inside the business if it can maintain a steady ROIC (of 10%, 15%, or 25%) for the next 5 years when the WACC is 15%.
We see that a 15% ROIC — equal to 15% WACC — values $1 in the company at… $1 exactly! This means that the company operating for 5 years, returning 15%, does not create value beyond the cost of raising the capital in the first place.
For 10% ROIC (below 15% WACC), the fair market value of $1 in the company is only $0.80, which means we shouldn’t buy in unless there is a discount. The reason the fair value is below the actual amount of capital in the company is because by operating for 5 years, the business is actually destroying value!
For 25% ROIC (safely above 15% WACC), the fair value of $1 in the company is $1.50 — this corresponds to a 1.5X multiplier. In other words, we would be willing to pay a premium today for the $1 inside the company because as the business operates, it is creating value putting that $1 to work.
This is the essence of Charlie Munger’s quote: if the business is creating long-term value, then even an “expensive-looking price” today will be a great investment over time. And if we can buy in at a steep discount today, then even better!
💰 How Quality + Time = Value Multiplier
What happens if we extend the model out beyond 5 years? Here are the results:
We see the pattern did not change — it just becomes more exaggerated. The 10% ROIC over longer times destroys even more value. This means the fair value today of $1 is only $0.30 if the business operates for 30 years.
On the flip side, the 25% ROIC over 30 years means $1 in the company today is valued at $12.20 — that’s over 12X multiplier because of long-term value creation with ROIC above WACC!
We see from this simple model the essence of Quality Investing as described by Charlie Munger: high returns on capital over time multiply value — and if you stick with it for the long run, then “you’ll end up with a fine result.”
Invest for the long-term and keep compounding knowledge! 📈🧠
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