The Secret to Buffett-style Investing: Unlocking the Power of High Returns on Capital

When it comes to investing in businesses, one of the most important things to look for is a company's ability to generate high returns on capital over a prolonged period of time. This is because businesses that can consistently earn high returns on invested capital are likely to continue growing and be more resilient in challenging times. One way to identify companies that have this potential is to look at their historical growth in book value per share. While it's true that a business might not always be able to reinvest all of its earnings back into the business, that doesn't mean it can't still be a good investment. A prime example of this is American Express, which prior to the 2008 financial crisis was earning returns of over 30% on equity, but was only reinvesting around a third of its earnings. When it comes to analyzing a business's return on invested capital, there are a number of different metrics and ratios you can use. However, it's important to keep in mind that these are simply approximations of a business's economic reality, and should be used as a starting point for further research. One metric that I personally find useful is the return on incremental equity. This metric involves calculating the return on the equity that has been added to a business over the past decade. Not only does this approach allow you to see how much of a company's earnings were reinvested, but it also gives you insight into the potential for future growth. For example, let's look at Johnson & Johnson (JNJ) as an example. Between 2000 and 2009, JNJ's shareholders' equity increased from $18.8 billion to $50.6 billion, which represents an investment of $31.8 billion. During the same time, JNJ's earnings grew from $4.8 billion to $12.9 billion, resulting in a return on investment of 25.5%. Additionally, by multiplying the rate of reinvestment (35.5%) by the return on investment, we can estimate an expected growth rate for earnings of 9%. However, it's important to note that this analysis doesn't take into account dividends or share repurchases, or JNJ's intrinsic value. While this type of analysis can be a great starting point for researching a business, it's essential to keep in mind that a good investment is more than just a high return on capital. Businesses that enjoy durable competitive advantages, such as Johnson & Johnson, are more likely to be stable and successful over the long-term.