I recently purchased a used vehicle off an auction site. The process was simple: I reviewed the cars currently on auction, identified the few that looked like good deals to me, and then found the one that best suits my needs.
My friend takes a different approach. He finds a car that he really wants and calls all the dealers in town, offering them a really low price. He tells them that if they ever really need to move inventory and are willing to accept his offer, give him a call and he’ll come by the dealership, cash in hand.
This difference in approach is akin to the different methods of finding attractive investments. Most people look around the stock or bond markets to find what seems to be most attractive, while a smart minority first finds a group of wonderful businesses, and then wait patiently until they can buy them at a bargain price. This brings us to the question at the heart of this article and possibly the industry as a whole: what defines a great company?
The Significance of ROC
Very simply put, a good company is one that can earn a high return on capital (ROC) over long periods. Let’s review an example: If I started a restaurant chain which went on to earn $100 million per annum, is this a success? It really depends on how much capital was needed to start and operate the business. If we used $10 billion, it would equate to a meager 1% return, but if the business only used $250 million, we’d be earning a fantastic 40% return on our investment. Essentially, a profit of $100 million can only be said to be good or bad in light of how much capital the business uses.
Let’s take a minute to analyze the latter scenario. I had the great idea to set up a chain of restaurants in underserved neighborhoods in a number of major cities and we were enjoying a 40% return ($100M/$250M). Here’s the catch: It won’t be long until my fellow capitalists notice and seize on my success by opening restaurants of their own.
As they encroach on my market, we will need to compete to maintain our market share. This may mean lowering prices (likely reducing our $100 million in per annum income) or updating my restaurants so they have more pizzazz (increasing our invested capital). Pretty soon, our return on invested capital will take a hit, and our business won’t be so attractive anymore.
Joel Greenblatt explains this concept perfectly in The Little Book That Beats the Market. Businesses that maintain a high ROC are able to reward shareholders over the long term.
A Business Fortress
So then, how does a company remain attractive for an extended period of time? By possessing a sustainable competitive advantage, or economic moat, as Buffett would call it. This may materialize in several different forms. Sometimes it’s a brand name (think Coke), while other times it’ll be a patent (drug companies) or a network effect (Facebook and Google).
Let’s take Google (GOOGL) as our example: over the last decade they’ve earned a ROC in the high teens (and a near identical sum on equity, because they have had a minuscule amount of debt during most of this period). Because they have more searches performed than competing search engines (with a 92.71% market share according to statcounter.com), their algorithms are able to endlessly improve more quickly than a smaller competitor, thereby cementing Google as the best search engine-per the American Customer Satisfaction Index, Google scored highest among its competitors for User Satisfaction-which keeps the trend going.
A business would need to be a fool to skimp and advertise with Microsoft’s Bing with only a fraction of the audience (2.73% market share). This is what enables Google to fend off the intruders and continually earn healthy returns.
How has this worked out, you ask? Well, over the last decade their income has increased more than four-fold (pre-tax income of nearly $40 billion in 2019) and their investors have been immensely rewarded with a 330% return, outperforming the rise in the Nasdaq or the S&P 500.
Contrast the economics of Google with Posco (PKX), the third largest steel producer in the world, headquartered in South Korea. With little differentiation between producers, steel is generally a commodity type business. As a result, Posco has earned roughly a 5% return on invested capital over the past decade.
Their business demands enormous capital investments to maintain the plant and equipment necessary to remain competitive, but will provide only meager returns on said investment. This is an example mediocrity, if not worse. So how have their investors faired? Sales have gone nowhere, profits have decreased in the decade since 2010, and shareholders have seen a decrease in the price of their holdings.
Wait for the fat pitch
A word of caution is in order: Even the best company will not justify an infinite price. McDonald’s has a long history of earning excellent returns on invested capital due to their brand name and scale, which provides them enormous leverage with their suppliers.
During the early 1970’s, the market recognized much of the potential in the company and bid up its share price. At the height of the Nifty Fifty (of which the company was a member) in January of 1973, McDonald’s sold for 86 times earnings, at about $0.96 per share adjusted for splits. As investors came to their senses, the price plummeted 68% to just $0.30 in 1974.
It took until mid-1982 to break the high price set in ‘73. That’s more than 9 years! No matter how wonderful a company is, paying too high a price is never a good idea. Just like Warren Buffett, value investors should sit on the sidelines and wait for the fat pitch.
This brings me to our conclusion and a lesson; we ought to invest like my friend buys his cars. Find wonderful businesses that we’d love to own, and only then patiently wait until, by the stupidity of the markets, someone will sell us a stake at a fantastic price.
Author bio: Judah Spinner is the Founder, President and Chief Investment Officer of BlackBird Financial. Mr. Spinner has over 10 years of experience as a security analyst. He bought his first stock at age 13, began raising capital from clients at 15, and was managing more than one million dollars at the time of his 18th birthday.
On behalf of his clients and his own account, Mr. Spinner outperformed the S&P 500 8 out of 10 years, racking up an annual compounded return of more than 18%. Mr. Spinner specializes in equity investments with a long-term time horizon and plays an integral role in the work of the firm.