A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time—with the potential to endure for decades [emphasis added]. When you find one of these, don’t just swipe right, get married.4
Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that [emphasis added]. So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.5
[Selling at low prices creates] a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com [emphasis added].6
When forced to choose between optimizing the appearance of our GAAP [generally accepted accounting principles] accounting and maximizing the present value of future cash flows [emphasis added], we’ll take the cash flows.7
Some of the best insight on the virtues of delayed gratification in creating long-term intrinsic value comes from studying Buffett’s comments on GEICO’s customer acquisition costs over the years:
In 1999, we will again increase our marketing budget, spending at least $190 million. In fact, there is no limit to what Berkshire is willing to invest in GEICO’s new-business activity, as long as we can concurrently build the infrastructure the company needs to properly serve its policyholders.
Because of the first-year costs, companies that are concerned about quarterly or annual earnings would shy from similar investments, no matter how intelligent these might be in terms of building long-term value. Our calculus is different: We simply measure whether we are creating more than a dollar of value per dollar spent—and if that calculation is favorable, the more dollars we spend the happier I am [emphasis added].8
At GEICO, for example, we enthusiastically spent $900 million last year on advertising to obtain policyholders who deliver us no immediate profits. If we could spend twice that amount productively, we would happily do so though short-term results would be further penalized [emphasis added].9
Buffett views these expenditures, which put pressure on reported earnings in the short term, as long-term value creating investments. In owner-related business principle number 6 of the Berkshire owner’s manual, he states, “Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.”10
Noted value investor Thomas Russo has often talked about companies that have “the capacity to suffer,” or the capacity to reinvest to build long-term competitive advantage at the cost of depressed short-term reported earnings. Usually, these companies have an ownership structure that keeps activist investors at bay. Usually, some individual or entity has enough control to adhere to a strategic path and build a long-term economic franchise without bothering too much about short-term profitability. Growing a business in a new market requires high upfront costs. These higher costs depress current earnings, which negatively affect the stock price in a shortsighted market. Most early upfront costs beyond production and distribution are put toward converting people into lifetime consumers as their income grows. Significant advertising and promotion is needed initially to maintain early market presence before a company sees growth in market share or profits. That process takes time and requires a lot of patience, which most management teams do not have. That nagging itch from shareholders, employees with stock options, and the management’s net worth measurements cause companies to make a little compromise here, hold back on some needed investment there, to feed the earnings machine, pacify Wall Street, and prop up the stock price. Just scratch that itch a little bit. It will feel so much better.
But once scratched, does the itch ever go away? This is doubtful. Companies end up getting entangled in the endless game of managing analyst expectations. By bowing to these expectations, they become complicit, and then it is hard to exit. They begin playing the earnings management game to avoid the short-term hit that’s likely to follow. Or they think it could threaten their tenuous hold on strategic control. Or they fear they may lose their jobs if Wall Street declares that the earnings are in a secular decline. Management teams that are influenced easily by short-term-oriented shareholders, like an activist, tend to focus on activities that drive short-term results at the expense of long-term success.
In the most recent edition of the book Valuation: Measuring and Managing the Value of Companies, the authors write, “We’ve found, empirically, that long-term revenue growth—particularly organic revenue growth—is the most important driver of shareholder returns for companies with high returns on capital. We’ve also found that investments in research and development (R&D) correlate powerfully with positive long-term total returns to shareholders.” At the same time, the book also notes that “in a survey of 400 chief financial officers, two Duke University professors found that fully 80 percent of the CFOs said they would reduce discretionary spending on potentially value-creating activities such as marketing and R&D in order to meet their short-term earnings targets.”11
Most managers are not willing to suffer upfront pain. So they focus on short-term results, which contributes to underinvestment in brand building, R&D, and other long-term growth initiatives, which in turn eventually leads to long-term pain. They cut current costs to prop up current earnings, rather than spend more now to gain much more later. Consequently, they hurt their chances of long-term success.
It is important to align your personal values with that of your investment. Buffett and Munger are masters of practicing delayed gratification, and unless you, as a partner in Berkshire Hathaway, are equally willing to delay gratification, you will end up as a frustrated shareholder.
Buffett is happy to forgo current profits for GEICO to acquire additional policyholders, but he is also willing to increase expenditures and their concurrent charges against earnings if warranted, because he always focuses on total lifetime value of every customer. When a business has a high ratio of lifetime value to customer acquisition costs, it’s rational to invest as much as possible in acquiring new customers. That is how Buffett thinks about advertising dollars spent on profitable customer acquisition by GEICO: in net present value terms.
In the insurance business, Berkshire Hathaway not only will happily forgo business and market share in the absence of profitable underwriting opportunities but also, in specific instances, will incur underwriting losses that hit the bottom line in the current year. In exchange, they acquire float that will produce income for many years in the future. What could be worse? All of the expenses are currently recognized, and all of the income will be recognized only in future years as the float produces investment earnings. This is delayed gratification in the extreme.
The question in all of these cases is this: Are you, as a shareholder, willing to give the same commitment to delayed gratification that Buffett and Munger practice? If not, you may want to revisit your participation in this security and in other securities with similar long-term-minded management teams. Keep in mind that only by resisting the marshmallows today will you receive the whole box of See’s truffles tomorrow.
Investors generally overlook businesses that are doing things that will create significant incremental earnings one to two