by Jacob Taylor
“Right, because they’re mobile,” I said.
“Yes,” he said as he coughed again. “It’s worth the initial test, and sometimes the results surprise us. This project has easily saved us tens of millions by avoiding swings and misses. We could have put out over a million dollars to build a full restaurant that ended up with low traffic. Remember back to operational leverage? Our errors show up as bad returns on invested capital.”
“So say, putting one dollar in and only getting two cents out?” I asked.
“Or even a negative number,” he said. “Being bad stewards of capital.”
“Is it that big of a deal?” I wondered aloud. “After all, you still have the restaurant you built.”
“Some CEOs would have you believe it’s not,” he said. “But a positive or negative ROIC is a huge deal when you look at the entire capitalistic ecosystem. Misallocation is bad for the company because we have less profits to reinvest. Where’s the internal eighty percent of funding going to come from? It’s bad for customers because we built in a location no one really wanted. It’s bad for the environment because we wasted materials and energy for a building that will likely be torn down. It’s bad for society because not making progress is a waste of everyone’s time and talent.”
“Wow,” I said. “A positive or negative ROIC tells you all of that?”
“Isn’t it amazing how when you view the world through this lens, capitalism puts everyone on the same team? Capital allocation done well is good for everyone at different levels. We don’t celebrate it enough.” I hate to admit it, but Mr. X was making some sense.
“Why don’t business people talk more about doing important work like that?” I asked.
“Some do,” he said. “My hope is that most don’t because they’re just doing the work rather than talking about it. That might be generous though.”
“I think I understand the second Buffett quote now,” I said.
“Now there’s a business person who gets it,” Mr. X said.
“Higher returns on capital mean more value is being created. Not just for the business or investors, but for the whole ecosystem,” I said, more to myself than to Mr. X.
“I think you’re starting to appreciate the importance of the capital allocator job,” he said. “It’s always bothered me how under-recognized it is for the wellbeing of humanity. I know it sounds like hyperbole, but good business decisions can positively impact us more than nearly anything else.”
We sat quietly for a time, both deep in thought. Mr. X’s coughing continued. I was sympathetic, but felt helpless to do anything.
He calmed down and we continued. “I’m going to be coming to California next week for business, so you won’t need to travel. I’ll come see you,” he said.
“That’d be great,” I said. My butt was suddenly relieved at the prospect of not being crammed into a middle seat again.
“Let’s keep the lesson going while I’m not coughing. There are some other big takeaways for ROIC. Especially when it comes to growing. Not all growth is good.”
“It seems like a rapidly growing business is what everyone wants, right? It’s all you hear in the press.”
“There is a strange fascination with growth,” he said. “Maybe a better term for growth would simply be “more.” If you’re doing something right, more is good. But if you’re doing something wrong, more is definitely not what you want. Return on invested capital can serve as the gauge that tells you if you’re doing something right or wrong.”
“When you say right or wrong, what do you mean?” I asked.
“I mean, are you giving the consumer something they value and are you delivering it in a cost effective manner? Think back to our straws,” he said.
“C-P-V. You have to be delivering more value than you charge. You have to charge more than it costs to produce,” I said.
“That right, ROIC tells you how effective you are.”
“I follow,” I said.
“Here’s a story to help you remember the dynamic between growth and return on invested capital. As a young man I sent away for Charles Atlas’s exercise program. It got me into training with heavy weights. You seem like you’re in pretty good shape. Do you ever lift weights?”
“Not really. I’m more of a runner,” I said. I suddenly felt self-conscious of my underdeveloped upper body.
“You’re at least familiar with the bench press exercise?” he asked.
“Yes.” I’d always stayed away from it after imagining myself succumbing to gravity and being choked to death by the bar. What a way to go.
“Imagine the bench press,” he said. “During my Atlas training, I learned you need to use proper form to avoid injury. Before you load up the bar with heavy weights, you must have your form correct, usually through practice with lighter weights. Does that make sense?”
“Sure, train with lighter weights until you get the right movement down. That’s why show-offs end up hurting themselves.” I wonder how much Vance can bench?
“That’s right,” he said. “In this analogy, your return on invested capital is your form. It shows you how well your product or service fits with what consumers want. Only after you have proper form as demonstrated through sufficient returns should you attempt to add the extra plates of growth and scale up.”
“So you do smaller scale testing to make sure you have adequate returns on capital before you try to scale up and grow?” I said.
He nodded. “What happens if you add too much weight without developing proper form?”
“You get hurt,” I said.
“Similarly, if you attempt growth without showing adequate returns on capital, you wind up destroying value and risking business injury, even death,” he said.
“Makes sense,” I said.
“It does, but you’d be surprised how uncommon it is in practice,” he said.
“I understand the third Buffett quote now. Growth can destroy value if it isn’t earning a return on investment,” I said. It was satisfying when the puzzle piece clicked into place. The old man was a pretty good teacher.
“Stop me if you’ve heard this one,” Mr. X said. “Some businesses lose a little bit on every transaction… but they make it up in volume!” He chuckled to himself as was his nature.
“I’ve heard that before, but I never understood enough to appreciate it,” I said.
“Would you like to hear a practical example for ROIC?” he asked.
“Yes, please. I do better with the practical.”
Mr. X continued, “For a long time, we kept everything in-house by building and running our own restaurants. As you can imagine, it takes quite a bit of money to buy a promising piece of land. Then we had to use more money to put up a structure and add all of the restaurant equipment. We were decent at developing these real estate projects that would turn into good sites for restaurants. It required a lot of money to grow, which kept us expanding slowly. We ended up with a lot of capital tied up in real estate. And the long run return on real estate is closer to three percent. See anything wrong here?” he said. He loved to bait the hook and test me.
I thought for a second, picking at a few fries that were left over. “Wait, didn’t you say earlier that Cootie earned around twenty percent returns on capital?”
“I did,” he said. “Keep going, you’re on the right track.”
“Well, if most of your capital was tied up in real estate earning around three percent, how do you get up to twenty percent?” I asked.
“Bingo! I asked myself the same question: how can we get better returns on our capital? Said another way, where was our organization able to create the most value for our customers, all while consuming the least resources? I made a surprising discovery. We weren’t the best at the real estate side of value creation. We shined when it came to sourcing quality ingredients, crafting an enjoyable customer experience, and strict attention to detail in operations. We were simply better at logistics than real estate. Remember, it’s a
fool’s errand to believe that you can be good at everything,” he said.
“I’ve paid attention to the behind-the-counter operation at Cootie--it’s very impressive,” I said.
“Thank you, that’s decades of iteration at work, one-percent at a time. We figured out we were more effective by focusing on what we were really good at--restaurant operations. We now let others help with the real estate side of the equation. Do you know what ‘franchising’ is?”
“I’ve heard of it, but I probably couldn’t explain it to someone very well,” I said.
“The definition of a franchise is the right to use a firm’s business model or brand. They had a form of franchising back in the Middle Ages, but it wasn’t until the 1960s that the concept really gained popularity,” Mr. X said.
“The franchisee, whom we carefully screen, has responsibility for the real estate side of the business. They get help from us on the operations and get to use the Cootie name and systems. In exchange, we get a percentage of their restaurant’s revenue. Cootie makes more money with less invested capital through franchising. Our invested capital goes into designing better systems and building our brand--not buying more real estate. That’s how our returns on invested capital are around twenty percent and not three percent.”
“It sounds like you’re leaving the franchisee the short end of the stick?” I said. Aha! The first slip up. He must be screwing over the franchisees. That’s capitalism for you, someone’s always getting shafted.
“Not really,” he replied. “The franchisee can leverage our decades of experience running restaurants. They make more money and earn a higher ROIC on their real estate than most of the other options they could do with that land. It’s a win-win relationship. We only participate in arrangements where everyone wins.” Hmm, that didn’t sound like Marx to me. I’ll have to keep digging. He’ll stumble eventually.
“Wait, why do you need food trucks and company-owned restaurants then?” I asked.
“Good question,” he replied. “We have to keep our finger on the customer pulse. We can’t do that without testing. And you need to control the entire process from beginning to end to practice good science.”
“I see--small scale testing,” I said.
“It also allows us to put ourselves in our franchisees’ shoes. If there’s something we’re struggling with, they’re probably experiencing the same issue. It’s all part of being a productive member in the ecosystem,” he said. A coughing fit came over him that was worse than any of the previous. It was bad enough that some patrons looked on with concern. How bad does it have to get before I call someone?
“That’s all I can do today,” he said between coughs. “I need to get out of this cold. Can you take a raincheck on the personal questions this time?”
“Sure, you’re the boss, Mr. X,” I said.
“Will you call Cathy to pick me up, please?”
I dialed Cathy and told Mr. X I’d catch a cab back to the airport after she arrived. He thanked me between coughs. As we waited, I noticed the crimson blood on his handkerchief. How much time did we have left?
CHAPTER 26
Travel sounds romantic at first. Until you have to do it again. And again. It turns into a grinder of both soul and body. Another crying baby on this flight?! I was very happy to avoid the airplane as Mr. X came to visit California. He sent me a Warren and Charlie two-fer a few days before his trip.
All financial assets can be made economic equals: “It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota--nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.” -- Warren Buffett
“In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s how we make all of our decisions.”
-- Charlie Munger
The old man wanted to see my campus. I had Mr. X and Cathy meet me on a corner near school. Cathy deposited him with me and bolted for a coffee shop to tackle her own work. I told them I had made a reservation for four at a nice restaurant tonight and I wanted them to meet my girlfriend Stephanie. Cathy, the keeper of the calendar, accepted enthusiastically.
Mr. X and I agreed we should take advantage of the nice California weather and walk around the campus for our meeting. Walking was a bit of an exaggeration. Mr. X now required the aid of a cane--doctor’s orders. Apparently a fall at that age is a death sentence. He shuffled as he gingerly planted his cane with every step. I hovered close by just in case he needed extra help. I had plotted out a course that would steer us near the most scenic parts of the campus. Despite our slow pace, Mr. X’s mind was as sharp as ever.
“Where does money come from in a business?” he asked innocently enough as we meandered through the brick buildings.
“Investors?” I guessed.
“That can be true, but I’ve always found the term ‘investor’ quite vague. Let’s see if we can clear things up. Did you know that most of the time when someone invests in the stock market, the business doesn’t see any of that money?” he said.
“Really?”
“No,” he said. “That money goes to pay off the owner of the shares you’re purchasing. You’re buying her out of her position. She takes your cash; you take her shares. It’s a trade.” Is his use of a female pronoun Cathy’s influence? I appreciated his progressivism.
“Remember though, the company doesn’t see any of that money. They can’t buy new equipment or pay employees just because you traded with someone. No new value is created. The stock market is what’s called a secondary market. It’s like a flea market for second hand goods,” he said.
“Like eBay?” I asked.
“Like eBay, if you prefer,” he nodded. “Except instead of Beanie Babies, you can swap ownership of public companies.”
“OK, that’s not quite as glamorous as Wall Street makes it sound,” I said.
“Indeed,” was all he added.
We made our way slowly toward a small pond, ringed with benches. Mr. X looked like he could use a break, so we staked out a spot to bask in the sun like lizards.
“Where do public shares come from to begin with?” he asked. He favored the Socratic method, which always made me think of “Bill and Ted’s Excellent Adventure”: So-crates, watch out for your robe, dude.
“The IPO?” I responded. Let’s hope he doesn’t ask me to explain that process.
“Very good, the company sells some or all of itself to the general public. It’s still a trade. In this case, the founders and early investors get the money, and the public become new owners. Unfortunately, the track record of returns for investors buying IPOs is terrible.”
“Really? Don’t you hear in the news about a hot new IPO that everyone wants to invest in?” I asked. “I’ve seen articles that say, ‘If you had bought company ABC at IPO, you’d be super rich.’”
“True, some end up working out, and occasionally, the returns for an investor are spectacular. But those home runs are few and far between and the odds are not in your favor. It’s closer to playing the lottery. Let me ask you a question,” he said.
“Shoot.”
“Who knows more about the business and what it’s truly worth: the public looking on from the outside, or the founders who built the company? Who knows the true upside or the hidden risks?” he asked.
“Obviously being on the inside, the founders must know more,” I said.
“That’s right. When you slave over a business for years to make it successful, it becomes your baby. Would the founder ever let go of her baby, unless the price was incredibly favorable for her?”
I shook my head no.
“And if it’s favorable for her, wouldn’t that by def
inition mean it’s unfavorable for the other side of the transaction? In this case, Joe Public. The founders know where all of the bodies are buried,” he said.
“It is hard to imagine them giving the little guy a deal for something they built,” I said. “Why would they?”
“That’s why buying an IPO is usually a loser’s bet,” he concluded. “Shall we keep walking, or are your legs too tired?” What a joker.
I helped him up and we continued our stroll. We walked under a large arch that was a well-known campus landmark. Young people walking by smiled; it looked like I was giving an elderly family member a tour. My “grandfather” is richer than your grandfather.
“Where does money come from to start a business?” Mr. X said.
“Well, it must be before the IPO because the business is already up and running,” I said.
“Good, think really small,” he encouraged. “Did you ever run a lemonade stand as a kid?”
“Sort of, for about two hours one summer. I got hot and bored and went inside to play Nintendo,” I said.
Mr. X frowned and shook his head, maybe mockingly. “Where did the money come from for your lemonade stand? To buy the lemons and sugar?”
I tried to remember how things had happened. “I had a little bit of money saved up, plus I borrowed some money from my parents.”
“So you were financed with both debt and equity?” he said.
“What…”
“I’m just teasing,” he said. “You put in money as the owner of the business. You owned one hundred percent of the lemonade stand and were entitled to any profits it produced. Assuming you weren’t too distracted by the video set,” he said. Old people never get tech names right. Is that out of active obstinance or just not caring to keep up with a changing world?