If there’s one piece of Buffett advice that investors should always live by is to try and invest only in companies with exceptionally high economic goodwill. By that, he means companies that are able to deploy their capital efficiently and have relatively low costs of maintaining their operations. Such companies can deliver their excess cash back to the hands of shareholders.
The ultimate example
When Buffett first bought into The Coca-Cola Company (NYSE:KO) back in 1988, he knew that he found the ultimate capital efficient business. Coke owns around $15 billion in property, plant, and equipment. It has $8 billion in long-term investments and more than $21 billion in cash and working capital. Altogether, that’s about $45 billion in capital. Against these assets, it can borrow roughly $42 billion – that’s long-term debt, receivables, etc. This is capital it doesn’t have to keep in the business because it has such a strong business and reputation, it can borrow at cheap rates. That’s been true, by the way, irrespective of the nominal level of interest rates. The Coca-Cola Company (NYSE:KO)’s real (that is, after tax and after inflation) cost of borrowing is extremely low. On a net basis, Coke runs its entire operation on only $3 billion in capital. And on this $3 billion in net capital, it produces annual cash flows in excess of $9.5 billion. That’s a return of 216% on net tangible capital. That’s a mouth- watering rate of return.
But that high rate of return on capital isn’t reserved only to consumer- brand names such as The Coca-Cola Company (NYSE:KO). From time to time, you can also find such examples in the internet sector.
The Coke of the internet space
The company that I wish to discuss makes its money from internet security and operates from Israel. Check Point Software Technologies Ltd. (NASDAQ:CHKP) is a leading provider of software that protects computer networks from malicious attacks. There’s a funny thing about internet security software. Once a business is used to using a specific software of one company, it isn’t likely to change and move to a competitor. I liken it to changing a doctor when you’re sick… you usually don’t want to do that. This competitive edge of Check Point Software Technologies Ltd. (NASDAQ:CHKP) shows up well in the results.
The company is gushing cash. It has grown its free cash flow at an average rate of 16.7% per year over the last 10 years. In fact, Checkpoint is now able to generate an astounding 71 times more cash than it needs to invest back into the business. Fortinet Inc (NASDAQ:FTNT), a fierce rival of Check Point Software Technologies Ltd. (NASDAQ:CHKP), generates only 6 times more cash than it needs to invest back into the business. Now, that’s the beauty of capital efficiency.