What produces high returns on invested capital? – Part 1
In this article I analyze the factors that contribute to a high ROIC, using Buffet's 1972 letter to Chuck Huggins, then CEO of See’s Candies, as a base for my thinking.
10 minute read
2 Main Paths to High ROIC
A business with attractive economics produces a lot of cash, and very little has to go back in–a low capital intensive business.
Generally speaking, companies that produce high returns on capital do so in one of two ways: by earning above-average profit margins, or by turning over its capital quickly.
Firms generally derive their high returns on capital through either having an advantage on the consumer side (high-profit margins) or on the production/efficiency side (high capital turnover).
This post will touch on where high margins come from, and then in my next post, I will outline what causes a company to have high capital turnover.
Where Margins Come From
There are multiple reasons why companies are able to consistently achieve high markups over their cost.
Some products are expensive, complex to change, and critically important for customers. These products are said to have high customer captivity. Not every user loves Bloomberg’s software, but the company is so integrated in most of its customers’ finance departments that it would be too costly to switch vendors.
Some companies have built valuable two-sided networks, allowing the companies to extract significant value from those users directly (e.g. American Express) or indirectly (e.g. Facebook, Airbnb, Google, don’t charge users, but collect high-margin revenue from companies that want to sell something to those users). These companies have created network effects.
Some companies have a product that is the only game in town. In Mexico, for example, there is only “one” stock exchange and central securities depository, Bolsa Mexicana de Valores and Indeval, both of these companies are owned by the same group–Grupo Bolsa Mexicana de Valores. Anyone who wants to buy or sell a security must use their service.
Some companies have scale advantages and are able to produce a product at a lower cost than competitors. Gruma is an excellent example, they sell 70% of the nixtamalized cornflower in Mexico, and higher volumes allow the company to produce it at 20% less cost than its competitor, Minsa.
Some companies have a product that consumers have difficulty avoiding–a “toll road”. Stripe is a toll road on every transaction that is made. Consumers have difficulty in avoiding it because there are very few other options available, and all have similar charges.
Finally, some companies are able to have high margins because of a strong brand name. This includes companies like Apple, See’s Candies, Coca-Cola, etc.
More on Brands
Brands can be divided into two categories:
Companies that offer a better product or service than competitors (e.g. Apple)
Companies that offer a product or service of similar quality to competitors, but are better at telling a story about that product (Coke, Tiffany’s, and Nike)
Most brands fall into the second category.
Coca Cola is refreshing, but the premium price it has over Pepsi does not come from tasting better. The premium comes from the brand’s history, reputation, nostalgia, happiness, and other factors that come to mind when you think of the brand.
A business that depends on the “story” is often more likely to be vulnerable to shifting consumer behavior. Other brands can also invest to create and tell a story.
Buffett Knew How Important the Sees Brand Was
See’s Candies is an example of a company that had a strong brand, but required a story that had to be told and an image to be maintained in people’s minds.
While it made delicious chocolate, the chocolate itself wasn’t that much different than other available alternatives.
In his 1972 letter to Huggins, then CEO of Sees Candies, Buffett emphasizes the importance of having a story behind the image of the brand.
“We might be able to tell quite a story about the little kitchen in California that has become the kitchen known ‘round the world.”
Buffet also hints at some fear that the brand could erode if it is displayed incorrectly:
“Brandeis has taken a number of our boxes and placed them on a counter with 25 other offerings of cheap bulk candy, and other run-of-the-mill products”.
Unless the product was presented well, it would be just another piece of chocolate. There is no pricing power and much lower margins in the cheap bulk candy aisle.
In Buffet’s mind, this aspect of image and presentation also applies to how the product is distributed:
“It seems obvious to me that if we push further with department store distribution, we are going to have very tight controls regarding merchandising conditions.”
Another important factor that Buffet mentions is exclusivity and scarcity.
“I also think we should put territorial limitations on the franchise. It should be very hard to get, available only periodically, and then (to the consumer) apparently only in limited quantities.”
I think Buffett’s comments on the importance of presentation and continuous storytelling imply that there is no guarantee regarding the sustainability of a brand.
While brands are very valuable, they are also very vulnerable. Brands can erode quickly under the right circumstances.
Summary of Discussion on Brands
A high ROIC can come from having high margins, thanks to a strong brand.
A strong brand can be from having a better product or service or being better at telling a story behind the image of a product or service.
Margins can deteriorate from a product or service that depends on its story if it’s not marketed or presented well.
In my next post, I will analyze where high capital turnover comes from and how it leads to a high ROIC.
Please feel free to check out Buffett’s letter: 1972 Buffett Letter to See’s Candies