The long-term value of any business hinges on its return on capital. Yet among the many problems a company faces when it gets bigger, one is that it will have a harder time earning above market rates of return on its excess capital. Let's examine this situation more closely to understand why.

Warren Buffett has publicly stated that Berkshire Hathaway's (NYSE:BRK-A) future performance will not come close to matching that of its past. Likewise, Mohnish Pabrai, a Buffett value disciple who began his investment partnerships in 1999 and has delivered annual returns in excess of 29%, told investors at his 2007 annual meeting that his performance going forward will, in all likelihood, pale next to his past achievements. Even during his partnership years of 1956 to 1969, Buffett routinely told his partners not to expect bigger and better results as time went on -- although for a while the partners were pleasantly surprised.

These warnings reveal the one certainty in investing: An inverse relationship exists between the size of your investment portfolio and the rate of return you earn on it. In his first year, Pabrai started out with $1 million under management and delivered a return of 70%. Now that he oversees more than $600 million, odds are quite slim that he can achieve that rate of return again.

The reason? Smaller companies have more market inefficiencies than larger ones do, in part because the big analyst firms simply don't pay attention to them. There's no money in it. Instead, the big firms are all watching Google (NASDAQ:GOOG) to see whether it can reach $1,000 a share. But in the meantime, a small company with a tiny following, such as Pinnacle Airlines (NASDAQ:PNCL), can announce that it will work out a contract with Northwest, and within a few months, with still virtually no one looking, its share price has tripled.

Bigger is not better
And now let's consider a larger company that everyone is watching, such as Microsoft (NASDAQ:MSFT), which has a return on equity of more than 39%. That's a phenomenal figure, but it applies only to the capital Microsoft requires to run the shop. Microsoft can't deploy its billions of excess capital -- some $21 billion in cash -- at a rate anywhere close to its return on equity. If it could, I assure you that Microsoft would be trading for a whole lot more. This situation is one reason the company paid out a massive special dividend a few years ago.

As a company grows, investing excess capital becomes a much more difficult task. And the truth is, the vast majority of CEOs are not great capital allocators -- as evidenced by the numerous studies showing that most acquisitions destroy value rather than create it.

Again, return on capital is the key to the long-term value of any business. Over the long term, it's hard for any stock to earn a return greater than what its underlying business earns. Thus, if a business earns 7% on its capital for 30 years, and you hold the company's stock for 30 years, you're not going to earn much higher than a 7% return, even if you bought the stock at a huge discount. Of course, the same principle applies even if the business earns more on its capital and you paid a greater amount for the stock.

Understanding this concept is critical to the success of any long-term investor. Charlie Munger understands it, and that's what has made him so instrumental in Berkshire Hathaway's success. Even though most people prefer to shine the light on Buffett, it was Munger who made Buffett realize that it's far better to "buy a great company at a fair price versus a fair company at a great price." And it explains why Berkshire Hathaway invested very heavily in companies such as Coca-Cola (NYSE:KO) and bought out companies such as GEICO back when they were much smaller.

For decades, these businesses have generated double-digit returns on invested capital, and so once you own them, you simply hold on to them. But the key is the return on invested capital, not merely the size of the company. Bigger is not always better.

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