30 July What makes a good business? By: YIS | Category: Blog


Imagine we have two friends both opening stores. Our first friend, Jack, wants to open a chain of candy stores. It costs him $2,000 to build a candy store, and each earns him $1,000 per year in profits. That’s a whopping 50% return on investment ($1,000 / $2,000)! In two years he has made his $2,000 investment back. In four years doubled his money, assuming the stores stayed just as profitable at $1,000/year. Pretty incredible business.

Now our other friend, Jill, wants to open a chain specialty pet stores called Just Rodents. It also costs $2,000 to build a store, but it’s a bad business, (who wants to own a pet rat, right?). And it makes only it $40 per year in profits, or a 2% return on investment ($40/$2,000). Both stores cost the same the to build, one just makes more profit than the other.

They both come to you and want you to invest and buy half of their respective stores for $1,000 each. Do you invest in Jack’s Candy shop or Jill’s Rodent Shop? Of course, the answer is obvious, you chose the higher return business (50% in this case).

A business that earns a high return on capital (or sometimes called return on equity or ROE) is always the best business. Think of the ROE as the amount that a business gives back to you each year as a shareholder. It’s the difference of receiving a $20 bill each year or a $10 bill each year. A 20% ROE (return on equity) is better than a 10% ROE, and Jack’s 50% return on capital business is phenomenal. But, is a business that earns a high ROE today always worth more than one that earns a lower ROE today? Not necessarily.

Take this example. Would you rather receive: $20 dollars today and then $10 dollars-a-day for the rest of your life, or $15 dollars today and $15 dollars-a-day for the rest of your life?

Answer: You’d definitely want to take $15 for the rest of your life. (The difference in case you’re curious is you’ll receive $350k for the $15/day and $233k for the $10/day.)

So, Jack’s Candy shop earns a fantastic 50% return on equity today. And this is great. But since everyone knows what the business is earning today, the real question is, can they keep earning those high returns years into the future? What happens when the Ice Cream Shop in town realizes that Jack’s Candy Shop is making amazing profits, so they start selling candy in their store as well. Or what happens when a retailing giant like Wal-Mart decides to open their own candy stores to compete? Does Jack have to lower his prices so that he only makes $200 profit per store, and that 50% ROE becomes 10% over time? These are the key questions an investor must ask himself.

There are a couple of laws. Under the laws of economics, any time a business like a candy shop earns exceptionally high returns, forces will come in to reduce those returns. If Jack’s candy shop is earning a 50% return on capital, like a magnet, this is going to attract a lot more people to open candy shops, charge lower prices, advertise more, and eventually those returns are going to come down. This is Economics 101: If a company earns a return on capital above the average, competition is going to come in and compete it away. High returns on capital attract competitors like bees to honey. And most high returns end up being whittled down to average over time.

Unless, however, this company has something unusually powerful that others can’t imitate. Warren Buffett called this an “economic moat.” Like a medieval castle, some very good companies are protected by a wide moat to keep competitors at bay.

The best companies are the ones that make high returns on capital, but are able to protect and grow those returns through a unique protection (moat) that makes it very difficult for those competitors at the gates to come in and take them away.