Buffett’s ROE Game: Coke in ’88 and OXY in ‘22Learn more about this firm
Dear fellow investors,
The news of Berkshire Hathaway’s purchases in Occidental Petroleum (OXY) has been seismic in our minds, but to most investors it has been but a whimper. We believe there are two main reasons for this. First, Buffett hasn’t had a hot hand in recent years, so the normal copycats aren’t quick to repeat Buffett’s actions. Second, he’s buying an oil company. Oil has been a three-letter swear word to most investors. Therefore, it’s been much ado about nothing.
As Ben Graham is famous for saying, “Price is what you pay. Value is what you get.” We believe this is exactly what Buffett is doing in his purchases of Occidental. More than this, it is the return on equity (ROE) game that Munger and him have been so interested in since their friendship began.
To make sure all the readers understand what we mean by Buffett’s ROE game, here is what Charlie Munger said in the 1995 Wesco Meeting:
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, 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.
As Munger points out, the primary decider of long-term return is not the discount too book value. It’s the return-on-equity or what we call the ROE game. This ROE game explains perfectly why Buffett and Munger were so interested in Coke in 1988. All readers must remember that Buffett was asked why he was paying so much for Coca-Cola at 18 times their 1987 earnings and four times book value in a stock market that was much cheaper than that. Below is what Coca-Cola’s ROE was from 1987 to 1996:
Source: Bloomberg. Data in millions of USD.