122 The Business of Value Investingmeans is that Microsoft could take $ 1 million, invest it in its opera-
tions, and earn $ 400,000. Microsoft could then take the excess capi-
tal and still earn that same 40 percent. It was able to do this with
billions of dollars, years before the Internet boom.
It is no surprise, then, that Microsoft stock rocketed for many
years after its initial public offering and why early investors, Bill
Gates, and company employees got so fantastically rich off the
stock. The company was compounding existing and excess capi-
tal at a phenomenal clip. Anytime you can do this for a sustained
amount of time, the intrinsic value of a business mushrooms and
eventually so will the stock price.
Microsoft still generates returns on equity of over 40 percent, yet
the stock price sits still. Microsoft is so huge and has so much cash that
now it is able to generate those returns only on the capital needed to
run the business. It can no longer take the excess capital and redeploy
it at such a high rate of return. This is why it paid a huge dividend a
few years back. It made more sense to pay out some of that excess cap-
ital to shareholders than to reinvest back in the business.
Anytime you locate a company that offers the talent and the
ability to redeploy its existing and excess capital at above - market
rates of return for any sustainable period of time, odds are the stock
price will follow suit. An ability to earn excess returns on equity sig-
nals that the company offers certain competitive advantages not
easily reproduced by its competitors.
In the 1980s, Warren Buffett bet over 20 percent of Berkshire ’ s
book value on the Coca - Cola Company. Buffett noticed, among
other things, that Coke was earning excellent returns on its equity
and deployed the excess capital into other infant markets. Berkshire
Hathaway itself is a huge capital deployment vehicle. It takes the
fl oat from its insurance company and any excess cash from its oper-
ating subsidiaries and invests the excess capital very successfully.
Berkshire has risen an amazing 7,000 - fold since Buffett took control
of the company in 1965.CH006.indd 122CH006.indd 122 9/2/09 6:58:11 PM9/2/09 6:58:11 PM