I just published my book review on “It’s Earnings That Count: Finding Stocks with Earnings Power for Long-Term Profits” by Hewitt Heiserman, Jr. The book contained a very interesting quote from Buffett that answered a question that was lingering in my mind for some time.
One of the things I didn’t fully understand was, what’s wrong with earning low margins in a business, so long as you are making positive profits? You hear about business leaders selling off or closing down lower margin businesses to “focus” on higher margin businesses. Jack Welch had the infamous philosophy that GE should be either the #1 or #2 of each industry it is in, or it should leave that industry completely. I always thought it was odd because even if you are #3 or #4, or you are making low margins, the fact that you are making positive profits, doesn’t that mean that it is better to keep those businesses because overall, you do make more money, and more money is always better than less money right?
Not quite. The thing is, even if a business is making positive profits, there is an opportunity cost (in the invested capital) to consider. If there are other opportunities available such that the invested capital can be making higher returns than what it is making in the low returns business, then it is not rational to pursue the low returns business. The company should either invest that capital in higher returns businesses or return that capital to its shareholders so that they can invest in higher returns opportunities themselves.
The book had a great quote from Buffett on his focus on maintaining high returns on invested capital. He told Malcolm Chace in 1965, then president of Berkshire Hathaway, that “I’d rather have a $10 million business making 15% than a $100 million business making 5%. I have other places I can put the money.” This quote captures the above very nicely.