WHAT MAKES RETURNS HIGH?
by Donald V. Potter
A single business that can earn high returns on investment, for example, pre-tax returns on net capital employed that exceed 25%, is the dream of every company.
Many companies never have such a business. Others have one for a while, but then the business goes down hill. A very few companies have one, or even several, and maintain high returns over a long period of time.
How do these companies achieve and maintain high returns? At any point in time, most high returns can be traced to external factors that enable a company to charge high prices. Management really cannot claim credit.
Long term high returns, however, usually are the result of management efforts to control costs.
External Factors Raise Price
“Most high returns are the result of temporary external forces.”
Most businesses that earn high returns receive these returns as a result of high prices. High prices, in turn, are possible because of forces largely outside management control. Among these forces are:
- High growth rates. Market growth is the most common force permitting high prices. High prices appear in many early-stage markets, like electronics and bio-technology. A market with an annual growth rate in unit demand over seven percent has a good chance of having attractive prices and high returns.
- Unusual growth in input costs. A rapid rise in the cost of purchased materials, as happened in industries dependent on oil in the ’70s, raises industry prices. A company blessed with a low-cost source of the material, or with an inexpensive substitute like hydroelectric power, often sees high returns as a result.
- Restrictions on competitive supply. These are usually the result of patents or government regulation. Pharmaceuticals have high prices and returns due to patents. So do a few semiconductor companies, especially Intel. The ICC’s regulation of the trucking, airline and railroad industries until the late ’70s gave companies in those industries high returns.
The problem is that these external factors often last only a few years. Growth rates decline as the did in plain paper copiers and personal computer. Sources of low input costs are depleted, copied, or cannot sustain a company’s growth, as happened with hydro-electric power in the aluminum industry. Legal rules can be readily changed, as happened with deregulation in the ’80s. External factors rarely yield long-term, high returns.
Superb Management Reduces Cost
Another road to high returns goes by way of low costs. A company that reaches a cost position well below that of its peers makes high returns in its industry. In good times, the returns are especially good, but high returns are possible even in hostile market conditions. Several examples illustrate the point:
- The beer, table wine and fast food industries have seen very tough times. But these tough times still yielded high returns for Anheuser-Busch, E&J Gallo and McDonald’s, each of which achieved a low-cost position because of economies of scale made possible by its dominant market share.
- The ’80s brought hostility to the aluminum and tire industries, but Alumax and Cooper Tire remained stellar performers because they concentrated on service to certain profitable customers very well.
In each of these industries, prices fell, and remained low for many years. Yet stars made high returns because they managed costs well.
Cost Management Keys are Size and Focus
“Long term high returns are due to management.”
Many hostile markets have one or two companies who turn in brilliant performances despite a dismal price environment. These companies achieve high returns because management controls costs.
Some companies control costs by leveraging their dominant sizes. McDonald’s and Gallo are more than twice the size of their next closest competitors. Managements of these companies can afford and will make, investments in labor-saving automation and software innovations (e.g., training and procedures standardization) before their smaller competitors.
Other companies are highly disciplined in their market focus. Cooper Tire and Alumax are examples of smaller companies who keep costs low by keeping their aim sharp on a limited number of target customers. The large scale of their bigger competitors works against these smaller companies, resulting in high costs in some functions, such as manufacturing and service. The best smaller company managements compensate for these disadvantages by avoiding the benefits and costs that their carefully chosen customers do not need. For example, they may have very low marketing and research costs because they avoid advertising and product development that their target customers do not need. To keep their low costs, these smaller companies stay away from customers who do not meet the strict criteria for their customer targets.
When a company has high returns due to external forces, it often allows all costs to rise with prices as it pursues volume. But this period of high returns is the easiest time to get firm control of the unit cost growth really needed to support unit demand growth.
(Note: This Perspective was written in the context of the economy in 1993. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)