“In terms of capital-intensive businesses, they’re just not as good if you can find an equally good business (...) that doesn’t require capital (...). You really want a business (...) that doesn’t take any capital to speak of and keeps growing, that doesn’t take more capital as it grows. (...) If you take the top four or five companies (...) they don’t take much capital, and that’s why they’re worth a lot of money. Because they make a lot of money and they don’t require the money to any great extent in the business,” Warren Buffett (Trades, Portfolio) explained at a Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholder meeting.
So it is quite obvious the renowned investor has a preference for companies that do not need much capital investment. But why exactly does he favor low capital-intensive businesses?
The high return on invested capital
One of the main reasons Buffett likes companies that do not require a lot of capital is the potential for very high returns on invested capital. When a business can efficiently generate profits without sinking a ton of money into plants, equipment, inventory, etc., it makes for a phenomenally profitable enterprise.
Take See’s Candies, for example. Berkshire Hathaway acquired See’s in 1972 for just $25 million. At the time, See’s needed only $8 million in capital to run its operations. With pre-tax profits over $5 million on that modest capital base, See’s was earning a terrific 60% return on invested capital when Berkshire took over.
Over the following decades, See’s invested very little incremental capital relative to the profits it produced. As Buffett explained, the company invested a total of just $32 million in capital expenditures over the years. Yet it generated over $1.3 billion in pre-tax earnings over that timespan.
This dynamic illustrates why Buffett gets so excited about businesses that can scale up profits without gobs of accompanying capital investment. The small denominator of invested capital compared to the earnings produced creates the fat returns on capital that gets value investors drooling.
Abundant cash flow for redeployment
Another benefit of low capital-intensive companies is they require very little of their earnings to be reinvested for growth. This frees up the lion’s share of their profits to be distributed to shareholders as dividends or share buybacks.
For acquisitive conglomerates like Berkshire Hathaway, this creates a perfect scenario. Buffett can deploy the excess cash flows generated by See’s and other non-capital intensive subsidiaries into acquiring whole new companies.
This gives Berkshire a “double-barreled” compounding effect. The company enjoys high earnings growth from the low capital-intensive businesses, and it can take those earnings and continually buy and build more businesses.
This is why Buffett says, “Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.” The abundance of excess profits is better served by being allocated to other opportunities.
Less vulnerable to inflation
In times of high inflation, capital-heavy businesses can really struggle. When replacement asset costs are rising, they may need to continually spend more just to replace depreciated assets.
Think of airlines that need to buy new planes as old ones age out. Or manufacturers that need to upgrade machinery and equipment regularly just to stay efficient. Their capital spending can balloon during inflationary periods.
Companies that require little capital investment, on the other hand, do not have this problem. See’s did not have to buy materially more equipment each year just to replenish its capabilities. As long as it could raise prices enough, its profits were not squeezed much by inflation.
This inflation resiliency gives low capital-intensity businesses another advantage in Buffett’s eyes. Their earnings power is not eroded as easily during rising price environments.
The challenge of scale
So it is obvious why Buffett loves low capital-intensive businesses so much. The high returns on capital, abundant excess cash flow and inflation protection are all hugely beneficial.
The problem is that great, low-capital-intensive businesses are exceptionally hard to find. And when Buffett does find them, they often do not come in a size large enough for Berkshire Hathaway to meaningfully invest in.
As Berkshire grew into an enterprise worth hundreds of billions of dollars, deploying tens of billions into acquisitions each year, it became harder and harder to put all that capital to work in low capital-intensive businesses. There simply were notenough brand-name consumer companies or software companies available at reasonable prices.
That led Buffett and his team to gradually expand their scope. They started acquiring more capital-intensive companies like railroads and utilities. These businesses require lots of infrastructure investments, so their returns on capital are lower.
But with Berkshire’s ever-growing cash war chest, they were some of the few opportunities big enough to absorb the conglomerate’s capital. Though their economics are not as impressive as See’s, railroads and utilities still produce reasonable returns that satisfy Berkshire. Buffett still views them as good (though not great) long-term investments.
Tips for investors seeking low capital-intensive companies
While Berkshire Hathaway’s massive size limits Buffett’s options, individual investors have an easier time finding promising low capital-intensive businesses to invest in. Though they may not make headlines, there are many “boring” companies with great economics that fly under the radar.
Here are some tips for investors seeking overlooked gems with low capital needs:
- Screen for high return on capital and low capital spending ratios. This combination signals efficiency in profit generation.
- Look for companies with a track record of modest capital expenditures relative to cash flows. This indicates capital discipline.
- Search for firms with long operating histories. The sustained success speaks to an enduring competitive advantage.
- Target “unsexy” businesses outside glamorous industries. Think food, beverage, household goods, utilities, insurance, and so on.
- Research consumer monopolies with pricing power. Brand loyalty and limited competition often allow pricing to exceed inflation.
- Study past recessions. Companies that have sailed through economic troubles often have durable advantages.
- Learn the industry well to assess competitive dynamics. Disruptor risk is lower in sleepy industries.
- Ignore small market capitalizations. Great economics matter more than size.
- Consider private companies. Many have high returns on capital but no pressure to deploy excess profits.
The enduring appeal of capital efficiency
Despite Berkshire Hathaway’s evolution, Buffett still favors the economics of low capital-intensive businesses. Their ability to compound earnings while conservatively deploying capital is an enduring hallmark of exceptional companies.
Capital efficiency provides a margin of safety and is the hidden fuel powering the most effective compounding machines. That is why, even as his conglomerate grew into capital-intensive businesses out of necessity, Buffett’s fondness for minimizing capital needs endures. It is the ultimate determinant of earnings power and lasting value creation.
Focus first on finding businesses with enduring competitive advantages that allow outsized profits without proportionate capital investment. Capital efficiency never goes out of style, no matter how big the investor’s stable grows.
