On page 9 of his 2009 letter to shareholders, Warren Buffett wrote:



"In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest. If our expectations are met – and we believe that they will be – Berkshire's ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead."



The paragraph articulated the importance of Return on Capital. It also showcased various operation level tactics Buffett practiced throughout his investment career when pursing high ROC. In short, an investor can





Avoid capital-intensive businesses completely

Cherry-pick high ROC within capital-intensive businesses

Pursue businesses that require little incremental investment to grow, if initial ROC is not appealing

Accept decent returns on incremental investment but design capital structure carefully to gain better returns

McLane. McLane is a "distributor of groceries, confections and non-food items". Distributors make use of the same asset --- trucks and storages --- repeatedly to generate profit and typically have appealing ROE. The industry ROE is 28% as of today. Accordingly, McLane performed exceptionally while other subsidiaries "suffered to one degree of another from 2009's severe recession".

MidAmerican. MidAmerican "owns a wide variety of untidily operations". Utilities generate stable income but need to invest heavily on infrastructure to serve existing and new customers. The industry fetches an average ROE at 18%. Consequently MidAmerican generated handsome earnings but all were retained for improvement and expansion. As it paid no dividend, investors sacrificed a chunk of profit.

NetJets. NetJets "offers fractional ownership of jets". It has to maintain a fleet of jets that requires huge amount of capital. It also has to face strict regulation and fierce competition faced by airlines. Using airlines as a proxy, its industry ROE is a much lower 10%. NetJets was "the premier company in its industry". But its financial outcome was a disaster. In the 11 years under Berkshire till 2009, it incurred big operating loss and its debt soared 20 times.

About the author:

Trustamind Author of ETF Ranking Newsletter.



An amateur trader / investor that tried many methods including buy and hold, technical analysis, quantitative analysis, day trading with pattern, and finally settled with fundamental analysis to discover undervalued quality stocks. Author of ETF Ranking Newsletter.An amateur trader / investor that tried many methods including buy and hold, technical analysis, quantitative analysis, day trading with pattern, and finally settled with fundamental analysis to discover undervalued quality stocks. Visit Trustamind's Website

Knowledgeable readers may want to skip to the next section if familiar with ROC.ROC is the ratio of a firm's net income over invested capital. A company with high ROC is preferred because it produces more income per each dollar invested by investors. Stock investors care more about, where equity is asset minus liability. With debt begin backed out, equity measures shareholders' portion of invested capital.ROE is quoted on popular financial websites. Though not interchangeable, it is convenient for us to use ROE as a proxy to ROC for the purpose of our discussion in this article.Although a lot of factors may affect it, ROC is largely shaped by a company's business model, which determines how income is extracted from asset. Companies with similar business models, e.g., companies in the same industry, generally have ROC at the same level.We pick three Berkshire ( NYSE:BRK.A ) subsidiaries mentioned in the same letter to illustrate the relation between a company's ROC and its financial performance. ROC is not separately reported for a subsidiary. We use average ROE of public companies in the same industry as a proxy.Investor can pursue high ROC with different approaches, depending on the investment opportunities they could discover, the amount of cash they would deploy, and how well they understand what they are doing as an investor.A company is capital-intensive if it requires more capital than labor to produce good or service. Although being capital-intensive does not equal to having dismal ROC, a capital-intensive business incurs additional risks and investors may want to avoid them if they have more opportunities than cash.Capital expenditure on plant and machinery is invested upfront and is expected to last for many years. If something happens to shorten its life span, investors are at loss. Chances are many things could happen. A natural disaster may strike and completely destroy the plant. Just look at what the 3/11 earthquake have done to Tokyo Electric Power. A competitor may invent a new production process and existing plant becomes obsolete. The plant is not destroyed but investors are still at loss because there is no value-preserving way to unwind the plant back to cash. A government may stipulate new regulations. What if First Solar ( NASDAQ:FSLR ) invested on a new plant and the next day Italy stripped off subsidies for solar energy?It is riskier if the plant is funded mainly by debt. The company has to generate income continuously to pay interest. A couple of months' dire performance is not acceptable as it may force the company into default. In the worst case it may end up in a bankruptcy court where investors lose their shirts.An investor can take a look in this area if the amount of his investable cash snowballed and he needs more opportunities.McLane is a suitable example. To be sure, McLane is heavy on physical asset. It owns thousands trailers and tractors, and tens distribution centers with millions square feet of space. Its high ROC comes from its business model that allows it to use the same asset over and over again and generate massive revenue. The total cost of asset is huge but the cost per unit of revenue is much lower. Actually this is the so-calledratio, which is revenue divided by asset. A good asset turnover means the company can extract more sales and thus profit from its asset and often leads to a rich ROC.Satellite TV and radio fall into this category. Serving one customer generally requires the same amount of capital that serves one million customers. When customer base is small, their initial ROC would be dull. But ROC explodes once customer base starts to grow. To illustrate, DirecTV’s ROE ( NYSE:DTV ) is 228% as of today. Even the struggling Sirius XM Radio ( NASDAQ:SIRI ) has a ROE at 35%.Nonetheless, whether it pays off is hinged on how real the company's growth potential is. If the business fails to grow, investors are left to hold a hot potato. It requires investors to have a thorough understanding of the business to succeed with this type of investment. But what does not?MidAmerican fits well here. As mentioned before, MidAmerican never paid dividend and stock investors sacrificed a chunk of profit. But Buffett is not only a shareholder but also a junior debt holder of MidAmerican.At the bottom of capital ladder is common stock, which comes in first to absorb loss if there is any. Then comes preferred stock. Preferred stock earns a predefined dividend, while common stock's dividend is at mercy of a company's management team. Debt is more secure than stock and debt holders earn fixed interest. Like wise, debt is classified into junior and senior levels. Junior debt comes before senior debt to absorb loss. To compensate it, junior debt pays interest at a higher rate than that of senior debt.As a student of Ben Graham, Buffett understands that senior and junior debts of the same company bear similar risk. A not so pleasant but striking example is Mortgage Backed Security that caused the latest financial crisis. Similar to senior and junior debts, MBS is sliced into tranches. Top tranche have perfect rating from rating companies because it is protected by not a single but multiple layers of lower tranches. But as it turned out, even top tranche MBS became toilet paper when crisis hit. The credibility of all tranches is bound to the same underlying asset. If the asset's value vanished, so did that of all tranches of MBS. The protection exists only in imagination.If the risk is about the same, why not hold junior debt and earn outsized interest?The table below shows MidAmerican's debt and interest from 2005 to 2009. Data are derived from Buffett's letters to shareholders. Numbers are in millions.The majority of MidAmerican's debt is senior debt held by outsiders. The debt pays a better-than-nothing interest less than 2%. By contrast,Berkshire holds its junior debt that has an interest rate about 5 to 10 times higher.The total amount of debt almost doubled from 2005 to 2009. It appears that Buffett funded MidAmerican's expansion mainly by debt. Funding it by equity is less attractive because MidAmerican pays no dividend. Plus the interest rate of senior debt is tempting to the debt issuer.Buffett also drastically lowered the amount of junior debt from 2005 to 2009. ConsequentlyBerkshire's risk exposure to MidAmerican, as well as its cost of capital, is lowered.The overall ROC of MidAmerican may not be pretty. But the return on capital invested by Buffett is handsome.No doubt that Buffett is at an advantageous position in the case of MidAmerican. He controls 90% of the company, so he has the power to design a capital structure attending toBerkshire's benefit. He also has the knowledge, and if he wants, the control of MidAmerican's operation so he knows the junior debt is safe. MidAmerican is a subsidiary ofBerkshire. Buffett backs MidAmerican's senior debt withBerkshire's outstanding credit which significantly lowers the interest rate. Sure senior debt holders do not earn much. But their investment is secure, perhaps more secure than Treasury bonds.Not every investor has the power Buffett has when it comes to investment. But if an investor wants to follow Buffett to buy a company's share, he would better first understand Buffett's logic.Last but not least, it is very important that a rich ROC does not constitute an outright buy recommendation. Investors also need to look at valuation. Buying a right business at a wrong price is not a winning strategy.