Here’s a great excerpt from Joel Greenblatt’s book – The Little Book That Beats The Market, in which he discusses the importance of finding businesses that can achieve a high return on capital, saying:
But here’s the thing. If capitalism is such a tough system, how does the magic formula find us companies that are able to earn a high return on capital in the first place?
To earn a high return on capital even for one year, it’s likely that, at least temporarily, there’s something special about that company’s business. Otherwise, competition would already have driven down returns on capital to lower levels.
It could be that the company has a relatively new business concept (perhaps a candy store that sells only gum), or a new product (like a hot video game), or a better product (such as an iPod that’s smaller and easier to use than competitors’ products), a good brand name (people will happily pay more for Coke than for Joe’s Cola, so Coke can charge more than Joe’s and continue to earn a high return on capital despite having competition), or a company could have a very strong competitive position (eBay was one of the first auction web sites and has more buyers and sellers than anyone else, so it’s hard for new auction sites to offer the same benefits to customers).
In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.
Businesses that don’t have anything special going for them (such as new or better products, well-known brand names, or strong competitive positions) are likely to earn only average or below-average returns on capital. If there’s nothing special about a company’s business, then it’s easy for someone to come in and start a competing business. If a business is earning a high return on capital and it’s easy to compete, eventually someone will! They’ll keep competing until returns on capital are driven down to average levels.
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