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
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
Bigger is not better
And now let's consider a larger company that everyone is watching, such as Microsoft
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
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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Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a value-centric private investment partnership modeled after the original Buffett Partnerships. He has no stakes in the companies mentioned. He can be reached at email@example.com. The Fool has a great disclosure policy.