The Power of Retained Earnings

I have been working on a new spreadsheet template that estimates management’s ability to allocate capital over the long-term. Here is a screenshot example using one of my favorite companies: AutoZone (AZO). I want to highlight one calculation, and then I’ll provide background and context on why this matters to investors. In the cell “S11″ (row 11, column S”), it shows that AutoZone has a Return on Retained Earnings of 14.25% between August 2005 to August 2019. That is a very good performance.

Figure 1: Return on Retained Earnings for AutoZone (AZO), Aug05-Aug19
Financial Data from GuruFocus (https://www.gurufocus.com/financials/AZO)

But before we get into the details of this spreadsheet, let’s provide some context.

Every year Warren Buffett writes a letter to the shareholders of Berkshire Hathaway. The company website has letters going back to 1977. Whereas most public company CEOs write a 1-page letter or 2-page letter, Buffett writes much longer detailed letters; last year in 2019, the shareholder letter was 19 pages long. For the first time in many years, he writes on the topic of retained earnings. The section titled “The Power of Retained Earnings” starts from the bottom of page 2 and runs through the end of page 5, comprising 1,156 words to thoroughly and patiently explain the power of retained earnings.

Buffett’s message is that many investors underappreciated the power of retained earnings prior to the publication of an obscure book in 1924 called Common Stocks as Long Term Investments by Edgar Lawrence Smith. But I wonder if even present-day investors underappreciate the power of retained earnings, despite the publication of Mr. Smith’s book and also Mr. Buffett’s letters to shareholders. Prior to the 2019 letter, Buffett also discussed retained earnings in 1978, 1979, 1980, 1981, 1982, 1983, 1984, 1985, and 1994. The topic of retained earnings deserved an annual mention in the years between 1978-1985, but there was a 9-year gap between 1985-1994 and a 15-year gap between 1994-2019. Since retained earnings is such an important topic, I want to discuss in further detail before getting back to the spreadsheet.

“It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was published. After all, it was no secret that mind-boggling wealth had earlier been amassed by such titans as Carnegie, Rockefeller and Ford, all of whom had retained a huge portion of their business earnings to fund growth and produce ever-greater profits. Throughout America, also, there had long been small-time capitalists who became rich following the same playbook.”

Warren Buffett, Berkshire Hathaway Letter to Shareholders, 2019

I think the mention of Carnegie, Rockefeller and Ford is signaling a message to shareholder. Understanding the power of retained earnings is no small topic of minimal importance; unlocking the power of retained earnings can produce mind-boggling wealth.

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