We often think of businesses that have low capital intensity as a positive. This is due to the fact that these types of business are often highly scalable and profitable. Therefore profit margins tend to be above average along with very high returns on capital. This makes sense – low capital investment coupled with high margin leads to superior returns on that capital. Perhaps the classic example is Microsoft (MSFT). Microsoft was able to corner the PC operating system market with their Windows platform which was highly profitable and highly scalable. It cost Microsoft very little incremental investment for each version of Windows that shipped once the initial investment was made. That being said there are very few Microsoft’s out there that have such a dominant franchise businesses with super high returns on capital.
With this in mind, I put forth the assertion that if a company is capital intensive AND can sustain above average returns on capital, it is indeed a valuable business to own. Why should this be the case? Bruce Greenwald discussed this very principal in his book Value Investing - From Graham to Buffet and Beyond. A company can create high barriers to entry with asset value. In other words, it can create a competitive advantage due to the fact that the asset value it has built can be very difficult to replicate. I will provide an example below.
Low capital intensive companies can achieve high returns on capital, but those lofty returns may eventually be eroded by competition. This is generally why extremely high returns may indeed be a red flag. Those sky high levels will attract completion and if a business can protect its position it will eventually decline. It is understandable that we may fall into this trap. We are taught early on that low fixed asset businesses are preferable as they can be highly profitable. The problem is that these returns may not be sustainable. However, a business that has high levels of capital intensity has built-in protection. Things such as a fully built out distribution infrastructure can be very costly and difficult to replicate.
Example: Target (TGT, Financial)
Many large and mature growth retailers fit this profile. By basic definition, Target Corp would be considered to be a capital intensive business. In order to grow and maintain a very large store base, a significant capital investment is needed. Yet even with this massive capital need, the shares have grown well over one hundred fold in the past 30 years. When a management team can run a superior franchise producing sustainable returns on capital, shareholder wealth will ultimately be created. A true franchise exists when those returns on capital can be protected for the long run. Lastly, It is very important to closely examine the firm’s capital structure. A heavy debt load may accompany a large fixed asset base. If future cash flow can’t service this debt bad things will happen (think General Motors).
So remember - when looking for potential investments, don’t immediately dismiss capital intensive business. It may be a built in competitive advantage.
