I call it capital-efficient businesses. And it’s my favourite type of investment.
I wrote about this in 2021. I believe this is a must-have for any investor’s portfolio, especially if you want to compound wealth.
This is not a new concept. I borrowed this idea when I read one of Warren Buffett’s letters. He first shared this concept in 1983.
Capital-efficient businesses generate a lot of cash profits without having to reinvest enormous capital to maintain their business.
This is a company’s free cash flow. It’s the cash profits left over after paying for what it’s needed to run the business each year – investing in equipment, building new plants, upgrading software and so on.
These businesses also produce high returns on their assets and consistently grow their revenues. You can tell by looking at a company’s return on equity (ROE).
A company with a 20% ROE, means for every $100 reinvested back into the business, it generates $20. This is pretty good. Most companies in Singapore don’t go beyond 10% ROE.
When you’re looking for capital-efficient companies, you want to watch out for companies that may delay reinvesting capital into their business for many years in order to conserve cash or even sustain their dividends.
Their cash flow might look better than they are. And their ROE may look good for maybe two or three years. But over time, their cash flow might drop over time as they realize they need to invest capital back into the business. To avoid these companies, look at a longer period of time say over the past ten years.
Let’s take a look at one example of a highly-capital efficient business – McDonald’s (NYSE: MCD).
At a $175 billion market cap, MacDonald’s is one of the biggest and oldest global fast food chains in the world. We know MacDonald’s is more than just selling burgers. It’s a real estate giant with a cultural icon.
My two boys recognize the huge, bright golden arches more than their math questions. That’s a big clue of a company’s strong branding.
What’s driving MacDonald’s capital-efficiency is its strong branding and ability to build a sustainable operating system.
In 2017, McDonald’s decided to push for an aggressive franchising strategy, heavily relying on both real estate ownership and licensing fees. Its revenues dipped a bit as it closed some of its company-operated restaurants.
However, profit margins started growing as it aggressively expanded its franchises.
Today, 95% of its outlets are franchises. These profit margins come from rent, royalties, and start-up fees. Its free cash flow has almost doubled since 2017 from $3.7 billion to $7.1 billion.
What’s more, it has been producing double-digits return on its capital…
Because of this, shares have gone up over 950% over the last 30 years. What’s more, McDonald’s started paying in 1976 and has paid a dividend every year after year. Including this year, that’s 51 consecutive years with dividend payments.
And it could do this because it has a highly capital-efficient engine for profit making.
In fact, if you had invested in McDonald’s over the last 20 years, your dividends would have grown to 16.7% yield on cost today.
This is what capital-efficiency actually looks like. Capital-efficiency is fueled by a company’s ability to endure competition, thrive and defy the law of capitalism. They usually sell products and services that keep customers coming back for more.
This means, as it continues to grow, these companies can maintain and even grow their profit margins, reflecting a durable competitive advantage. This protects and grows profits over the years.
Warren Buffett built Berkshire Hathaway based on the foundations of capital-efficient businesses – See’s Candies, Coca-Cola, American Express, Apple etc. He looks for companies that have a strong consumer franchise like McDonald’s, which fuels growth for his investment fund.
I wrote in my email to members back in 2021:
As long-term investors, you must have capital-efficient businesses in your portfolio to compound wealth.
Sometimes, investing can be simple.
Willie Keng, CFA
Founder, Dividend Titan
