Buffett's Capital Riddle

Here's a riddle for you. Say you could own one of two companies:

• Company A, which earns $2 million with $8 million in net tangible assets, and costs $25 million to purchase.
• Company B, which earns $2 million with $18 million in net tangible assets, and costs $18 million to purchase.

Furthermore, let's assume both companies will have flat unit volume for the foreseeable future. Which one would you pick?

A value investor's dream
Hmm ... let's think about this. If you pick Company B, you get more tangible assets, the same amount of earnings, and you're buying at a multiple of earnings of 9, versus 12.5 for Company A. Not only that, but wasn't Ben Graham, the godfather of value investing, a proponent of buying stocks at a discount to asset values?

Yet as surprising as it may seem, the value investor's perfect company isn't the one you should pick. Company A is the right choice. Here's why.

Inflation and capital returns
First of all, inflation, like death and taxes, is one of the inevitable events in life. So it's almost a given that both of these companies will have to deal with the effects of inflation.

Now, let's look at the returns on tangible capital (ROTC). Company A earns $2 million on $8 million of net assets, which represents a 25% ROTC. Meanwhile, Company B earns $2 million on $18 million, or an 11% ROTC.

If inflation causes price levels to double, both companies would need to double their earnings to $4 million in order to keep up on an inflation-adjusted basis.

Thus, if unit volumes were flat, both companies would have to sell the same product at twice the price. However, the key here is that both companies would also have to double their capital investments. Working capital, such as accounts receivable and inventory, responds quickly to inflation. And fixed assets, like plants and equipment, eventually need to be replaced at inflation-adjusted prices.

Cheaper improvements, better returns
Thus, we assume that Company A would need to add another $8 million in capital to double its earnings, so it'd be earning $4 million on $16 million in net tangible assets, or a 25% ROTC. Company B would need to put in another $18 million in capital to double its earnings. So it'd be earning $4 million on $36 million, which is an 11% ROTC. In both situations, both companies earn the same ROTC as before. However, you can see a big difference when you look at the new valuation.

Keeping the multiples the same, the value of both companies would double. For Company A, which had a value of 12.5 times earnings, the value would go up from $25 million ($2 million earnings x 12.5) to $50 million ($4 million earnings x 12.5).

Similarly, Company B, which had a multiple of 9 times earnings, would rise from $18 million ($2 million earnings x 9) to $36 million ($4 million earnings x 9).

Here's the trick: Company A's owner only had to reinvest $8 million in additional capital to get a $25 million increase in value -- or a 3-to-1 return. Company B's owners had to invest an extra $18 million to get an $18 million increase in value, or a 1-to-1 return.

In the real world
As you can see, in an inflationary world, less is more. In the riddle above, Company A is actually See's Candy, and the full description can be found in Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) 1983 annual report. Because See's has pricing power and rock-bottom capital investment levels, inflation actually makes the company more valuable as time goes on, because the company's high returns on capital compound, with minimal additional capex requirements. See's, which was bought for $25 million, has earned a cumulative $1.5 billion pre-tax for Berkshire since purchase.  

If you're trying to find a few more high-ROTC companies, just check out Berkshire's portfolio -- Washington Post (NYSE: WPO), Stock Advisor recommendation Moody's (NYSE: MCO), Inside Value pick Coca-Cola (NYSE: KO), and Procter & Gamble (NYSE: PG) are great places to start looking.

Related Foolishness:

• Buffett's Words of Wisdom: Part 2
• Buffett's Equity Investment Strategy
• The Worst Mistake You Can Make