Last time we learned about Marginal Return On Investment, or MROI. The maths is pretty convincing, isn’t it? As usual, however, theory doesn’t necessarily play out in practice! The practicalities of MROI are fascinating as it feeds into the booms and busts of industries. A good grasp of MROI practicalities will significantly improve your evaluation of growth opportunities, and navigate potentially risky situations.
In business competition is the largest force affecting our MROI. The world is competitive. Everyone wants extra dollars in their bank accounts. So, let’s think through the effects of competition and how it relates to investing for growth.
Back to Charlie and his business. Charlie’s store, Cinnamon Charlies, currently produces a 20% ROI. Based on history Charlie thinks a similar MROI is realistic. He reinvests his profits by building new stores to expand capacity. However, after noticing Charlie’s profits, aspiring entrepreneurs want to replicate his success by entering the biscuit business. Imagine your competitor now – the person on your dartboard!
Charlie has a problem if the taste and texture of Cinnamon Charlies are easy to replicate. Without product differentiation, Charlie will likely sell fewer biscuits. More biscuit sellers for the same number of biscuit eaters. Secondly, if the biscuits taste the same, Charlie will have difficulty telling customers to pay more for Cinnamon Charlies forcing him to match competitors’ prices. The easiest way to convince consumers to buy your product is to cut prices. However, this risks Charlie’s ROI making him nervous.
When you cut prices your costs remain the same so profit per biscuit sold sinks – therefore ROI too! Or, Charlie holds prices the same but sells fewer biscuits causing a similar profit reduction – reducing ROI. Without differentiation, market forces would bring Charlie and his copycats’ businesses to a 15% ROI – not bad, but lower than what Charlie was reinvesting in his profits.
And everyone lived happily, ever after…THE END.
Except… Of course, that never really happens.
You see, the copycats don’t stop there. A 15% ROI is still much higher than the standard market return (6%-8%, historically). So, the high ROIs of the industry continue to attract market entrants reducing each participant’s share and charging lower prices to attract customers further reducing profits and industry-wide ROIs. This cycle will repeat until ROIs in the industry approach the market return (6-8%). Entrepreneurs will be indifferent between investing in a general 6%-8% ROI business and biscuit businesses offering a similar ROI.
In fact, IT CAN GET WORSE!!!!! Let’s say the ROI of the industry has now been eroded to 11%. Again, not bad at all, but not quite the 20%, or even 15% that it was. Now all the newspapers are writing about the crazy profit being made in the biscuit business. Suddenly a mass wave of people opens biscuit stores trying to get in on the action. And that weird guy down the road who you smile awkwardly when walking on your way to work – even he is gloating about success in the biscuit business.
The biscuit industry has become over far too saturated with competition. Suppliers still need to incentivize customers to buy their biscuits. Competition, however, scares everyone into dropping prices fast. ROIs keep falling, now at 2%. That is 2% below the yield on government debt of 4%! This is a classic example of economic booms and busts that occur in markets. Participants extrapolate recent success (high ROIs) long into the future without considering that other people may try and do the same thing! A very costly mistake.
History is littered with such examples. A classic example is the gold rush. Everyone and their uncle go to dig for gold when the prices are high. Lots of gold is produced… Prices crash due to excess supply. Everyone is taken out. Look at the bankruptcies occurring in electric vehicles right now. It is a similar story. And I can guarantee this pattern will repeat itself long into the future.
Controversial opinion: Artificial Intelligence is next!
Ok, this must be frustrating. First, I told you that we need to look at historic performance, but now I am saying that looking at recent success is dangerous… GREAT! Give me two more minutes – I earned some credit so far.
So, what conclusions can we draw from this?
We must consider how competitors, or potential competitors respond to a high ROI. Can they easily get into the same business? What prevents competitors, or new entrants, from doing the same thing?
To earn a high ROI consistently over a long time your business needs a moat – a special circumstance, or structure that protects your profits. A moat is the forces that prevent other economic agents from entering a market you serve and taking or reducing the profits of your business/industry. They could be economic, psychological, sociological, geographical, and/or regulatory. Something that makes it difficult for others to replicate your success.
Another way to describe the idea of a moat is “barriers to entry”. What forces act as barriers to entering a market? Check out Porter’s Five Forces or The Little Book That Builds Wealth for more on this topic, although my blog cover this soon.
Types of Competitive Advantage:
- Intangible Assets (Brand, Patent, Licenses, IP)
- Cost Advantages
- Switching Costs
- Network Effects
Hence if the three-year average ROI of your business is very high, there is likely something special about your business, current environment, or something preventing others from doing the same thing otherwise your above-average ROI would have been competed away.
Luckily for Charlie, he has been in the biscuit business for a long time and developed a secret recipe no one can replicate. His biscuits just taste better. This better quality protects the ROI of Charlie’s business. Since customers like Cinnamon Charlie’s taste more, he can charge a much higher price and maintain a similar sales volume, maintaining a high ROI and MROI on future investments – Happy days for Charlie!
Let’s look at it from the other extreme, and what I would generally call a below-average business – a small, independent Café. Before I begin, let me make clear that I respect anyone who works in a café, or tries to start a coffee shop. I love good coffee and am grateful for it. My enjoyment of coffee, however, does change the fact that it is generally a bad business (ignore Starbucks for now).
There are thousands of cafés; 2 alone on the block where I live. It doesn’t require a prohibitive amount of money to open a coffee shop, nor rare speciality knowledge to make a good cup of coffee – just some good quality beans and a decent barista video on YouTube. The likelihood is Joe’s coffee is similar to Jane’s. Moreover, there are many substitute drinks to get a hit of caffeine. Competition is intense and will eat away at your prices till profits hit the “market ROI”.
Restaurants are similar. You compete with every restaurant on your street, block, area, and city – you name it. The competition is enormous. People put their blood, sweat and tears into creating a good experience for little reward (ROI) to compensate for the effort and risk. There are just too few barriers to entry.
So how should one invest for growth? It probably doesn’t come as a surprise that I don’t have the golden ticket to grow your business… I have, however, come up with a list of questions that may help you decide whether reinvesting to grow your business makes sense. I hope the question checklist will help you make better ROI and MROI-oriented decisions.
- What is the 3-year average ROI of your business?
- What is the MROI you expect to receive on the new investment?
- Does the investment contain more, less or the same level of risk as your current business?
- What is the spread between the expected MROI of reinvesting in your business vs the risk-free rate, and the historical market return? See ROI article for a definition of spread.
- Am I getting compensated adequately for the risk I am taking? (Higher ROI!)
- How easy is it for a new player to enter your business/industry/market?
- What are the barriers to entry in your industry?
- How long can you continue to invest at the same MROI, considering competition and the increasing size of your profits?
- Can I be more efficient with the capital I have already invested, generate the same profit and not harm my business? (this is a nuanced point and something I will explain soon)
Unfortunately, some of you will realize that reinvesting your hard-earned profits into your business is not a good idea. While that may be disappointing news, it should feel good that you can redirect your money to more productive lines of business. Should you adjust your financial decisions accordingly your net worth will be drastically different in the long run, – remember that compound interest chart!
Before looking at your financials and concluding, that your business is not a “high ROI, or MROI business” it is important to see the potential profitability of your company. By looking at your financial statements one can work out the likely financials if the business was optimized. Such analysis is nuanced and is exactly the type of work I want to help with!
If you have questions and are curious to learn more REACH OUT PLEASE 🙂
For those of you who have a high ROI business, high MROI and a long runway to reinvest, you are very, very lucky!