Adjacent Progression asks:
When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there's money left over, it's a profitable company. And the bigger the profits, the better the company.
And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you're using a framework to understand and assess businesses, it's fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.
Our focus on net profits is probably excessive. Perhaps we need to move up the income statement.
For me, there are two elements to consider with any business’s returns – sales margins and capital turns.
- How much can you make per dollar of sales?
- How much can you sell per dollar of capital you tie up?
Most investors and analysts pay too much attention to margins and too little attention to capital turns. In Alice Schroeder’s discussion of Warren Buffett’s investment in Mid Continent Tab Card Company, she mentions that Buffett looked at margins and capital turns.
Gross Profitability Matters More Than Most Investors Think
It is not necessary for a company to have high margins – and certainly not pricing power – to achieve truly remarkable returns on capital. And it's definitely not necessary to have a high net profit margin from the business's earliest days.
But you do need some basic evidence of a strong business model. What is a strong business model?
There are countless qualitative ways of looking at a business model. I’ll propose one basic quantitative check:
Gross Profits / ((Receivables + Inventory + PP&E) – (Payables + Accrued Expenses))
This number should start looking good – and keep looking better pretty early in a company’s history.
Look, Amazon (AMZN) is an expensive stock. I’m not going to argue otherwise. And it’s got low margins. But it also doesn’t tie up capital in the business. And it’s got the same gross margins Wal-Mart (WMT) does.
So, to me, Amazon is a proven business model quantitatively. And qualitatively I feel its competitive position will be better in five years than it is today. I think Wal-Mart’s will be worse.
Now, Amazon’s operating margin is worse than Wal-Mart’s. But I’m not sure Amazon’s business is worse. And I actually suspect it’s better.
This is what I mean when I say we sometimes focus too much on margins.
The Need to Self-Fund
Can a company develop a sustainable competitive advantage without earning strong returns on capital relative to its peers?
It’s possible. But, remember, Amazon is a rather weird example of a company that developed strong advantages early on without making good profits. By the time Amazon was strongly profitable, it already had a solid competitive position.
How common is this?
Amazon went public in a bubble. In fact, one of the reasons why Amazon’s management felt they had to expand so quickly in the early years is that it was still possible for new entrants to raise a lot of equity financing. The bursting of the bubble was one of the best things that ever happened to Amazon.
Once an industry matures even a little bit, self-funding – the use of retained earnings in the business – becomes a critical part of future growth. It is often the fuel that drives growth.
Retained earnings are the most reliable form of fuel. For this reason, a company that earns a higher return on its invested capital isn’t just more profitable – it’s better able to grow the business reliably.
Consider the example of an industry growing 7% a year. One company has an 8% after-tax return on unleveraged net tangible assets. The other has a 4% return on after-tax return on unleveraged net tangible assets.
Putting aside the issue of how safe it would be for a company with a 4% after-tax return on capital (basically, 6% before taxes) to borrow anything, there’s still the very real problem that Company A can grow the business 8% a year without leverage – which is fast enough to maintain or even grow market share. Meanwhile, Company B can’t. No matter how much customers may prefer Company B’s product to Company A’s product – if Company B is starting from a position with a 4% after-tax return on capital – it really can’t self-fund growth of more than 4% a year.
It's Hard to Keep Growing Sales Faster Than Assets
To maintain market share in most industries, it is necessary to increase capital pretty close to the rate at which the overall market is growing. So, if Company B wants to maintain its market share – it really needs to get half its growth capital from debt.
Maybe the business is very stable, and maybe the cost of debt is consistently below the 6% pre-tax return on capital Company B can achieve. But if Company B can safely borrow with a 6% pre-tax return on capital, Company A should be able to safely borrow with a 12% pre-tax return on capital.
Can Company B keep pace?
Sure. If Company A doesn’t borrow – and Company B does – the two companies can start from the same size and grow capital at the same rate over time.
But, if Company B thinks scale is so important it’s worth borrowing to grow 8% a year despite only being able to self-fund 4% a year – maybe Company A will think scale is important enough to try to grow 16% a year.
Well, Company B really can’t do that. If you have to increase invested capital to increase sales and both Company A and Company B refuse to use any debt to grow – then obviously Company A can outgrow Company B to the extent Company B’s return on capital is both lower than the growth in the overall market and lower than Company A’s return on capital.
Likewise, if Company A and Company B are both willing to borrow to the hilt – then Company A can still outgrow Company B. Although, in this case, if Company B’s product is preferred to Company A’s product it may be possible for B to grow a little bit faster than A. Of course, if Company A really can’t grow that fast, it really won’t borrow that much.
Any way you slice it, there is an advantage in having a high return on capital. It allows for the charting of a more reliable growth path.
What if You're Not The Market Leader - And You're Not Earning a High Return on Capital?
In industries where returns on capital increase with market share, the danger of being either a company with lower market share or a lower return on capital is real.
The danger of being a company with both a lower market share and a lower return on capital – probably means your chances of overtaking the leader are miserable.
How can you solve this problem?
You can borrow more than your opponent in an industry where returns on capital increase with market share. If returns on capital are poor when everyone has low market share but good when everyone has high market share – it might make sense to try to sprint for cover so to speak.
But this is a pretty reckless strategy that is only necessary in industries where key variables – like pricing and asset turns – are outside of the control of individual companies. In an industry like that, your only possible advantage is a cost advantage. So rushing to gain sufficient scale makes sense.
But there’s a better way in many industries. And that’s to find some way to achieve a return on capital advantage that can allow you to self-fund growth.
For examples of two industries with totally different defensible positions consider the case of Boston Beer (SAM) and Royal Caribbean (RCL).
Royal Caribbean has far more market share than Boston Beer. Depending on whether you are using price or volume, Royal Caribbean has anywhere from 12 to 25 times more market share in the cruise industry than Boston Beer has in the beer industry.
Everybody knows beer is a better business than cruises. And Boston Beer earns great returns on equity without using debt. While Royal Caribbean ekes out a modest return on its capital.
Scale is important in both industries.
But there’s a critical difference. Boston Beer is already in a position within its industry where it earns enough on its capital to completely self-fund its growth. As a result, the major constraint on Boston Beer’s market share growth is the relative attractiveness of its product in the beer industry.
Is the main constraint on Royal Caribbean’s market share growth the relative attractiveness of its product in the cruise industry?
I’m not so sure. I think there’s a very real risk that the cruise industry can grow faster than RCL can self-fund. Which means RCL has to use debt just to hold its market share steady.
Boston Beer doesn’t have to do that.
Now, don’t get me wrong. Boston Beer will never overtake Budweiser and have a leading position in the U.S. beer market. I can promise you that’s not going to happen.
But the reason it won’t happen is because Boston Beer’s product has limited appeal. The product is not positioned to be a blockbuster brand.
That’s a marketing constraint. Not a funding constraint.
RCL has a funding constraint. It’s actually possible for people to prefer an RCL cruise to a Carnival (CCL) cruise and yet for RCL to run into a lot of trouble expanding its market share versus CCL.
It's possible. But it's not that easy without taking more risk than CCL is taking at the same moment. And consistently taking a little more risk – being always a bit more aggressive than your opponent – is hardly a recipe for reliable long-term success in any business.
This is not true for Boston Beer. If Boston Beer’s product positioning allows for a doubling or tripling of its market share – Boston Beer’s business can self-fund this growth.
Because Boston Beer is already earning a high return on capital. Much, much higher than the rate of growth in its industry.
Royal Caribbean is not.
So, yes, investors do sometimes over emphasis today’s profits over the future conquests a great competitive advantage can provide.
But you need more than time, opportunity, and determination to grow. You need capital too.
The easiest place to get that capital is from your own successful operations.
So for most companies, a lot of tomorrow’s capital will come from today’s profits.