Retained earnings is one of the most powerful assets that a company can have and investors who recognise this will benefit for years to come, according to iconic investor Warren Buffett, a lesson true almost 100 years ago as it is today. 
In the latest investment letter to shareholders in his investment vehicle and conglomerate Berkshire Hathaway, Buffett noted the impact that retain earnings can have on a company, a lesson first documented almost a century ago.
Edgar Lawrence Smith’s 1924 book ‘Common Stocks as Long Term Investments’ – “a slim book that changed the investment world”, said Buffett (pictured) – noted the effect that retained earnings can have on a company.
A book review by renowned British economist John Maynard Keynes – and highlighted by Buffett – summarised the crux of Smith’s message as: “Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business.”
Thus, said Keynes, there is an element of compound interest in reinvesting.
“It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was published,” said Buffett, commonly referred to as the ‘Sage of Omaha’ for his Nebraska roots.
“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.”
He added: “Nevertheless, when business ownership was sliced into small pieces – ‘stocks’ – buyers in the pre-Smith years usually thought of their shares as a short-term gamble on market movements.
“Even at their best, stocks were considered speculations.”
One example of the compounding effect of reinvesting can be seen below with the S&P 500 index.
Performance of index over 20yrs
Source: FE Analytics
Though not a particularly high dividend payer has generated a significant total return, when payouts have been reinvested. The index has made a price return – in US dollars – of 147.96 per cent against a total return – with dividends reinvested – of 225.32 per cent over the past 20 years.
The effect of retaining and reinvesting earnings is today well understood by investors and has been a cornerstone of the investment strategy employed by Buffett and business partner Charlie Munger for some time.
The pair prefer to deploy the funds their firm retains into the businesses it owns.
As such, Buffett said its internal investments in “property, plant and equipment” has totalled $121bn in its own portfolio holdings over the past decade and it remains a top priority in the years ahead.
“At Berkshire, Charlie and I have long focused on using retained earnings advantageously. Sometimes this job has been easy – at other times, more than difficult, particularly when we began working with huge and ever-growing sums of money,” he explained.
Elsewhere in the letter, Buffett highlighted the top-15 stock investments for Berkshire Hathaway, which had a total market value of $248bn at the end of 2019 for an outlay of £110.3bn.
Top holdings by market value included names such as Apple, Bank of America, Coca-Cola, American Express and Wells Fargo.
Yet, these are not ‘a collection of stock market wagers’ to be sold in the event of downgrades by Wall Street banks, an earnings miss, Federal Reserve actions, possible political developments, economists’ forecasts “or whatever else might be the subject du jour”.
These were holdings that on a weighted basis were earning more than 20 per cent on the net tangible equity capital required to run their businesses. In addition, these earn their profits without employing excessive levels of debt.
“Returns of that order by large, established and understandable businesses are remarkable under any circumstances,” he said.
“They are truly mind-blowing when compared to the returns that many investors have accepted on bonds over the last decade – 2.5 per cent or even less on 30-year US Treasury bonds, for example.”
However, Buffett said neither he nor Munger would attempt to forecast the long-term interest rates and the potential impact they could have on investments.
“Our perhaps jaundiced view is that the pundits who opine on these subjects reveal, by that very behaviour, far more about themselves than they reveal about the future,” he explained.
“What we can say is that if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments.”
Buffett caveated this by warning that anything can happen to stock prices where there could be drops of 50 per cent or even greater occasionally.
Nevertheless, the combination of the compounding effect documented by Smith in his book and ‘The American Tailwind’ – a belief and optimism about the potential of the US economy he highlighted in last year’s letter – “will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions”.