The Secret Warren Buffett Used to Become One of the World's Richest Men

Editor's note: "It's the single greatest investment secret that has ever been discovered," Porter writes.

Learning and using this secret will put you in the class of investors with legends like Warren Buffett.

Today's Masters Series essay is adapted from the December 2012 issue of Stansberry's Investment Advisory. In it, Porter explains how to identify companies that can generate huge returns for patient, long-term investors... how to spot "value traps" (and more important, how to avoid them)... and walks readers through a classic example of this secret at work...

The Secret Warren Buffett Used to Become One of the World's Richest Men
By Porter Stansberry

Let's make a fundamental point about investing...

Most investors obsess about growth. They want a story about a company that's poised to experience massive growth. And yes, growth is very good. But you can't forget that the point of growth is to generate capital for shareholders.

How many Internet companies actually did anything to enrich their shareholders? Out of hundreds, maybe just a handful of them. Their growth was a mirage.

Always remember... Capitalism is about capital – how much you earn and how much you keep.

Thus, in Stansberry's Investment Advisory, we judge companies primarily by how efficiently they produce cash. We're interested in how much cash a company generates per unit of sales. And we're interested in how much of this is reinvested into the business (through capital expenditures or acquisitions) versus how much is simply returned to the company's real owners – its shareholders. And we're very interested in the price per share we have to pay to capture our share of the cash the underlying business is producing.

Most investors completely ignore a lot of businesses that produce little earnings growth on an annual basis. Nevertheless, these companies can generate massive returns for patient, long-term investors. They do so because they've become extremely capital efficient.

We write about this secret frequently because we think it's the single greatest investment secret that has ever been discovered. Warren Buffett used this secret – along with the capital-raising power of insurance companies – to become one of the world's richest men.

Let me show you, again, how to do it.

Measuring capital efficiency is easy. Anyone can do it. All you do is compare the amount of capital that's returned to shareholders each year in the form of cash dividends or net share buybacks with the revenue it generates.

If a company generates $100 of revenue and distributes $40 to shareholders, we'd say it had a capital efficiency of 40%. These cash flows allow investors to rapidly compound their gains by reinvesting the dividends. Even if the company doesn't grow much, its shareholders will still become extremely wealthy.

Highly capital-efficient companies tend to produce annual compound returns of about 15% a year. Few investors make this much in their own portfolios, no matter what strategy they claim to be following. But consider the long-term total returns earned by these companies over a recent 30-year period:

• Walt Disney (DIS): 3,123% (12% annualized)
• Hershey (HSY): 3,366% (13% annualized)
• Coca-Cola (KO): 3,819% (13% annualized)
• Clorox (CLX): 4,677% (14% annualized)
• McDonald's (MCD): 5,682% (14% annualized)
• Colgate-Palmolive (CL): 6,074% (15% annualized)
• Johnson & Johnson (JNJ): 6,157% (15% annualized)
• Tiffany (TIF): 8,572% (16% annualized)
• Microsoft (MSFT): 35,238% (22% annualized)
• Oracle (ORCL): 36,307% (22% annualized)

These are all what we'd call "high class" companies. They are extremely capital efficient. They don't have to spend much money investing in their businesses because their primary asset is their well-established, good reputation.

These companies possess huge amounts of what Buffett calls "economic goodwill." That's an asset that doesn't show up on the balance sheet. It's an asset that can't be purchased with any given amount of capital investment. It's simply a well-deserved reputation for quality, consistency, value, and customer service.

It seems simple... but it's a very hard thing to get right. The companies that have it tend to keep it.

You'll find that investors looking for capital efficiency (like us and Buffett) tend to focus on these kinds of consumer staples because they tend to have large amounts of economic goodwill. Thus, they are tremendously capital efficient.

If you're a Coca-Cola man, you're not going to switch brands. As long as Coke delivers the same high-quality product at the same reasonable price, you'll stick with it. Coke doesn't have to build lots of new plants or constantly create new products. It doesn't even have to spend a fortune on advertising. It has an established, loyal, and ready base of buyers... and a large moat around its business, thanks to brand loyalty.

It's unlikely to grow rapidly. But these companies can generate massive returns for patient, long-term investors.

And as you're looking for these companies, you must keep two incredibly important risks in mind...

Remember, it's easy to spot capital-efficient companies: You compare a company's capital that's returned to shareholders through cash dividends or net share buybacks with its revenues. The more capital a company can distribute, the better. Even if the company doesn't grow much, its shareholders will still become extremely wealthy.

Here's the thing: Not all of the companies that pass this "test" are worth owning.

Obviously, you can't ignore the basics of valuation. If you pay way too much for these businesses, your returns will disappoint. Beyond the basic value determination, the capital-efficiency approach has two significant problems.

First, a lot of companies – especially resource companies, like gold miners or oil producers – convert assets on their balance sheets (reserves) into cash earnings. These firms can sometimes look far more capital efficient than they really are because they delay the purchase of additional reserves for a long time.

You have to be careful to accurately measure the real costs of the company's production – including the costs to replace reserves. You can do this by measuring capital efficiency across a long period of time, typically 10 years. This allows you to measure a company's capital-investment expenses even when they're infrequent.

Second, this kind of analysis tends to highlight one type of company... the so-called "value trap." These companies appear to be great values because they throw off nearly all the cash they generate... but they're doing so only because their products and services are rapidly growing obsolete. These companies are essentially in "runoff" mode.

"Runoff" refers to an insurance company that has gone bust because the expected claims it faces are more than the capital it can raise. It exists only to pay out cash until it's all gone.

The same thing happens to companies whose products have grown obsolete. Imagine a pay-phone manufacturing and servicing business. Or a CD case maker. Or Kodak. The iconic filmmaker didn't need to build new chemical plants or develop new kinds of chemical-film products because demand for chemical film was disappearing.

Investors frequently believe they can manage these kinds of permanently declining businesses in a way that extracts all the cash each year... because there's really no ongoing business to invest in.

Avoid these situations at all costs. If there's even a hint that a business is involved in a product or service that faces long-term obsolescence, don't get involved. Ever.

I've seen many great investors – folks far smarter and wealthier than I am – fall flat on their faces trying to beat a sales-decline curve with larger dividends. In my experience, it never works. Expenses and problems mount faster than cash can be paid out, almost every time.

Again... If you decide to focus on capital-efficient companies, your biggest risk is that you'll end up buying companies that can't grow at all. These companies often "look" good on the basis of capital efficiency. But they're not.

Fortunately, this risk is pretty easy to mitigate. Just ask yourself this question: Is it likely that my children or grandchildren will desire this brand and this product in 20 or 30 years?

Obviously, you can't answer this question with any real certainty. However, I can say without hesitation that my kids and grandkids are likely to enjoy simple, branded consumer products known for consistent quality and consumer loyalty... such as Hershey's chocolate... Coca-Cola's soft drinks... and McDonald's hamburgers.

Remember... these are high-class companies. They don't have to spend much money investing in their businesses because their primary asset is their well-established, good reputation. They won't grow rapidly. But they will likely make shareholders who buy at the right price rich for decades to come.

Using just the information contained in today's essay, a little bit of common sense, and a little bit of discipline, you can become a world-class investor using this strategy.

And yet... very, very few people will pursue this approach.

I believe most investors think this strategy is simply too boring... or too good to be true. They say, "All we're doing is buying very well-run, extremely capital-efficient stocks and reinvesting the dividends? What about trading? What about technical analysis? What about options?"

Look... you can do all those other things if you want to. But almost no matter what else you decide to do, you will NOT beat the results of a value-based, capital-efficient strategy over the long term.

Let me show you again with one more classic example...

Buffett's holding company, Berkshire Hathaway (BRK-B), first acquired a stake in See's Candies in 1972. See's Candies was a high-class business with good profit margins, a loyal client base, and terrific capital efficiency.

Buffett would say the company possessed large amounts of economic goodwill. I'd call it capital efficient. Look what's happened...

Buffett is looking for companies that produce high annual returns when measured against their asset base and require little additional capital. He is looking for a kind of "financial magic" – companies that can earn excess returns without requiring excess capital. He is looking for companies that seem to grow richer every year without demanding continuing investment.

In short, the secret to Buffett's approach is buying companies that produce huge returns on tangible assets without large annual capital expenditures.

With this in mind, take a look at the table above. Over 35 years, See's has grown its earnings by 4,100%... while growing tangible assets by only 500%. As Buffett pointed out in his 2007 letter to shareholders...

This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of [See's Candies]. In the meantime, pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire.

Does that sound like a business you'd be interested in? See's only required $32 million to be reinvested in its own business, but yielded $1.35 billion in payments to its owners.

That's the power of a capital-efficient business. And it's not hard to put it to work in your investment account.

Is it really that hard to judge which high-quality companies are very likely to retain their brands, their customers, and their business models long into the future? Is it really that hard to buy these stocks when they are trading for a reasonable price (say, 10 times cash profits)? Is it really that hard to simply reinvest the dividends?

No, it's not. All the things I'm suggesting you do with your long-term investments are actually easy to understand and implement.

I'm convinced that it is almost impossible for investors following any other kind of strategy to beat the long-term results of investing in high-quality, capital-efficient companies and reinvesting the dividends.

I'm sorry it's boring... but it works.

Good investing,

Porter Stansberry

Editor's note: Investing in high-quality, capital-efficient businesses is one of the simplest and most important things you can do to protect (and grow) your hard-earned savings. But it may not be enough...

You see, Porter has identified a disturbing trend that is spreading across America right now. This has only occurred a handful of times in our nation's history... but each was followed by dramatic changes to the U.S. economy and the markets. Without exception, the value of our currency plunged... stock markets cratered by up to 50%... and millions of ordinary folks saw the value of their savings slashed virtually overnight.

Porter and his team of analysts have just prepared a presentation explaining it all, including exactly what this trend is and why it is happening again... how it's likely to play out this time... and the simple steps you can take to prepare right now. Click here to see it now.