Friday, January 16, 2015

High Returns on Capital vs High Returns on Incremental Capital

The importance of high returns on capital has been covered a number of times in prior posts over the years.*

Well, it's not just the overall return on capital that needs to be considered. Some good businesses can generate very attractive returns on capital but not nearly as much on incremental capital. Naturally, some not so good businesses, whether they are growing or not, don't earn an attractive return on capital on much of anything. In this context, here's what Warren Buffett said about Coca-Cola (KO), See's Candies, and Buffalo News at the 2003 Berkshire Hathaway (BRKameeting:**

"The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense. It's an enormous advantage."

One thing I think gets too little emphasis capital allocation decisions -- and doesn't get challenged nearly enough -- is the probability that the capital needed to pursue incremental growth will produce lousy returns or losses.

Questions like: Is the capital that's being allocated in pursuit of growth likely to produce an attractive rate of return adjusting (qualitatively) for the risks and considering alternatives? Are the range of outcomes narrow or wide? Is the worst case acceptable?

In other words, maybe the company will get bigger -- even impressively so -- but the shareholders end up no richer or even worse off and management ends up with a huge headache. Well, that headache just might lead to a core business that's not getting the attention it needs.

A number of otherwise sound businesses just can't get high returns on incremental capital. So it makes little sense for them to invest for growth. Unfortunately, this reality doesn't necessarily prevent the capital from being allocated imprudently anyway.

Intelligent capital allocation is one of those hard to measure but extremely important contributors to how much per share intrinsic business value will change, for better or worse, over time. Maintaining a comfortable financial position -- one that supports the business even in very difficult economic environments -- and competitive position is all-important. These things interact. Financial strength and flexibility allows the focus to be on creating/enhancing durable competitive advantages over time.

A business with a moat has a long-term competitive advantage.

Buffett calls activities that increase those advantages "widening the moat" and is paramount for investors.

Capital that's allocated to build, or at least maintain, long-lasting competitive advantages should take priority over, well, pretty much everything else.

Buffett on Widening The Moat

Wide Moat Businesses at the Right Price

Investment decision-making should come down to what will produce the highest returns on capital, with all risks and alternatives carefully considered, over the long haul. That, first and foremost, includes incremental investments aimed at protecting and strengthening the existing franchise(s).

The fact is that growth is too often pursued for its own sake and ends up destroying investment returns. As an example, costly and less than successful international expansions comes to mind. Lots of effort and capital put to work that ends up producing subpar results and even losses. Before meaningful capital is put at risk some healthy skepticism isn't the worst thing. Opportunity costs matter. An ill-conceived expansion or acquisition can become an expensive and high risk distraction. On the other hand, growth (whether organic or through acquisition) can at times be both high return while also making the moat wider.***

It's just not inevitably the case.

Some businesses have substantial financial strength along with durable competitive advantages but not much ability to make high return incremental investments. In those cases buying back stock can make a lot of sense if the shares are selling at a plain discount to per share intrinsic value.

From the 1984 Berkshire Hathaway shareholder letter:

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders."

The pursuit of dumb growth at the expense of moat widening initiatives should be avoided. This seems like it should be obvious but, even with good intentions, growth initiatives too often end up producing lousy or negative returns at significant risk compared to simply buying back a cheap stock.

Charlie Munger added this at the 2003 Berkshire meeting:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

There's too much emphasis on growth with the implied or explicit assumption that all growth must be a good thing. Well, growth is just not necessarily a good thing.

There's too little emphasis on returns on capital (incremental or otherwise) and "widening the moat." 

Considering their importance to investors these things still often don't seem to get the attention that's warranted.


Long position in KO and BRKb established at much lower than recent prices

* Charlie Munger explains it this way: "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."
** From notes taken by Whitney Tilson.
*** Or, at the very least, does no damage to the existing moat.
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