Here’s what Warren Buffett says is “the worst sort of business” for investors
In his 2007 letter to Berkshire Hathaway shareholders, Warren Buffett said: âThe worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.â
I think investors can learn a lot from this one simple insight.
Growth at all costs
In general, a business with the potential to grow over time is a good thing for investors. But investors need to pay attention to what’s involved in achieving that growth.
A lot of the time, growth involves heavy investment in equipment or machinery. And this requires the company to commit cash that could otherwise have been returned to shareholders. By itself, this isn’t a problem. But itâs important to make sure that the projects the business is putting money into are ones that can generate a decent return on the invested capital.
Other things being equal, a firm that grows its profits by £1bn by investing £6bn is better than one that needs £12bn to achieve the same growth. Obvious, I know, but it’s crucially important. The former company can return £6bn to investors as dividends in a way the second company can’t. And this is what Buffett means by requiring significant capital.
A firm that invests heavily at low rates of return is what Buffett calls the worst type of business. In this situation, investors would be better off with the cash as dividends.
A FTSE 100 example
Since 2015, BT‘s (LSE:BT.A) generated £22.15bn in net income, of which it has returned just under 44% to shareholders as dividends. That means it has retained around £12.4bn.
Despite this, the firm’s operating income has fallen from £3.78bn to £3.44bn. And a higher share count means things aren’t better in per share terms despite recent buybacks.
BTâs problem is that its Openreach business has a lot of expensive infrastructure to maintain. And in an inflationary environment, this can require a lot of cash. Furthermore, the company’s ability to pass on the effect of higher costs is limited by Ofcom. That’s why I don’t much like the stock from an investment perspective.
There are however, some reasons for optimism. The UK’s currently moving to fibre infrastructure from copper and this should mean lower costs and higher returns for BT.
Returns on copper investments are highly regulated, but Openreach does have pricing power when it comes to high-speed fibre products. And this could be a game-changer.
I’m avoiding it
Businesses with high capital requirements arenât always bad investments. Buffettâs investments in rail and energy subsidiaries come under this category. Importantly though, Berkshire earns a good return on its investments in those operations. But this doesn’t seem to have been the case with BT in recent times.
The move to fibre could change things. But the firm’s retained the majority of its net income and with no real growth, investors might well have preferred a cash dividend to invest elsewhere.
In general, Buffett’s preference for companies that grow without high capital requirements is worth paying attention to. And that’s why BT isn’t on my buy list.
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Stephen Wright has positions in Berkshire Hathaway. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
