BERKSHIRE HATHAWAY AND TOBACCO HISTORY PART IV
WARREN BUFFETT - ASSET ALLOCATOR
Warren Buffett’s history with RJR stock shows how he thinks about investing. But we can learn a broader lesson from him. He calls himself an “asset allocator.” He says that this is his one real skill and had he been born at any other time in history, this skill would have been worthless. To apply his talent, he needed a capitalist economy that allowed him to freely buy and sell (mostly buy). He says, with humorous understatement, that his asset allocation ability would have been of little use if he were a European serf in the Middle Ages where his only asset was a mule. You have no opportunity to allocate assets if you spend all day looking at the south end of a north-bound mule.
WHAT IS ASSET ALLOCATION
Asset Allocation is choosing where to invest the cash flow you receive from whatever source. For most companies, the choices are 1) plow money back into your current business 2) acquire new businesses 3) repay debt 4) pay dividends to shareholders or 5) repurchase outstanding shares of company stock.[i]
Buffett excels in making these choices. He points out that most executives are woefully unprepared to allocate capital. They have earned their position by excelling in some other management roll. Let’s look at R. J. Reynolds’ asset allocation record 1960-1984. I covered this in detail in my book Going Down Tobacco Road. It is ancient history, but it is still a timely example 63 years later. Corporate executives still misallocate capital. 70% of acquisitions never achieve a return sufficient to justify them.
RJR was lucky because it had one big advantage. The tobacco business earned 20% annual return on equity and threw off huge amounts of cash. RJR paid a consistent dividend and occasionally repurchased shares, but most of its cash flow went into new investments.
Initially, Reynolds confined its expansion to tobacco related businesses – Archer packaging for tobacco and other outside products and Tobacco International selling cigarettes in foreign countries. But in 1960 the Company began aggressive acquisitions in packaged foods, container shipping, oil exploration and production (international and U.S.), wines and spirits, fast food restaurants, and several smaller ventures.
The summary below shows the performance of the business units for the 40 years 1949-88 categorized as Tobacco and Acquisitions (Non-tobacco). The contrast in results is startling. The three tobacco operations represented 26% of capital investments and 88% of the dollars returned on the investment. The return on equity (ROE) for tobacco was 20% annually; non-tobacco returned only 2.4%. This raises the question - Why did RJR not commit more funds to Archer and International Tobacco, given their outstanding returns? The answer is complex, and we cannot know exactly what was in the minds of RJR management. A simplistic answer is that they were uncomfortable going into international markets, and “glittery” possibilities at home distracted them. Unfortunately, those “glittery” things often proved not to be gold.
The acquisitions fall short compared to Warren Buffett’s rules. RJR did not give the question, “What can go wrong?” enough attention. And no acquisition met Buffett’s target rate of a 15% current return. The acquisition purchases were made at a 15.4 P/e ratio when RJR was selling for a P/e of 6.9. Fifteen acquisitions had a 6.5% initial return vs. Buffett’s minimum 15%. (All data are dollar weighted)
A detailed list of the 15 acquisitions is available here. [LINK]
This asset allocation record is probably why Buffett decided to sell his RJR. He bought it at a time when the stock was pricing the tobacco business at an extremely low value. He enjoyed the upward revaluation for a few years, but probably had little confidence in RJR’s asset allocation going forward. That mistrust was later justified when RJR bought Nabisco Brands, its largest acquisition by far, at a P/e of 14.5 and a hurdle return of 6.5%.
RJR stock suffered from its acquisition record, but the story had a happy ending for shareholders. In late 1988, a Leverage Buyout bidding war doubled the price of the stock in a few weeks. The buyer overestimated the value of the company, and it was not a successful investment for the new owners.
In an RJR analysis, I created an “alternate universe” in which RJR did NOT diversify away from tobacco. The conclusion was that the stock could have achieved the same fortuitous result for shareholders while remaining a viable company. My alternate universe did not assume a heavy investment in international tobacco, a highly profitable business. This thesis was proved decades after the Leveraged Buyout when Japan Tobacco acquired RJR Tobacco International. Tobacco International has suffered for decades from lack of management enthusiasm and financial support. Once its Japanese owner gave it the resources, it became a success.
The good news for tobacco investors is that the five major companies have learned from the past. Little of their capital is directed to acquisitions outside their basic business, redefined as “nicotine delivery systems.” [ii] Many analysts are betting that new nicotine products will be successful.
[ii] My friend Dr. Claude Teague coined the term in the early 1970s. Claude was vilified, but 50 years later, the term is accepted in the tobacco industry.