The Quality Series · part 5 of 13
If I had to name the single most important factor behind long-term outperformance, it would be what Buffett called economic goodwill — to me, the primary measure of a business’s capital efficiency. I first wrote about it in 2016, and it has been the cornerstone of how I screen businesses ever since.
In plain terms: a business that earns an unusually high return on the physical assets it actually needs, and does not have to keep spending heavily to keep earning it. When both are true, profits and cash flow grow faster than the capital spending behind them, and the surplus is cash that can go back to shareholders.
Buffett first set it out in the appendix to his 1983 letter to shareholders, and his own example there is still the clearest. See’s Candies earned about $2 million a year on $8 million of tangible assets. An ordinary business earning the same $2 million needed $18 million. Now suppose inflation doubles the general price level. Just to sell the same amount of goods, each business must double the assets it runs on: See’s has to find another $8 million, while the ordinary business has to find another $18 million — more than twice as much, for no real growth at all.
I look for it in two places in the numbers. Capital spending stays flat or falls as a share of sales while free cash flow rises as a share of sales. And each dollar of capital spending produces more cash than it did five or ten years earlier.
Fair Isaac Corporation (NYSE: FICO), from 2015 to 2025, shows it as clearly as any business I know. Capital spending fell from 3% of revenue to 2%, while free cash flow rose from 13% to 37% of revenue. In dollars, FICO produced $108 million of free cash flow in 2015 on $25 million of capital spending, about $4 for every dollar spent. In 2025 it produced $739 million on $39 million, about $19 for every dollar, and that is after counting the software it now builds for its own use as capital spending.
FICO 2015–2025: free cash flow and capital spending, each as a share of revenue.
FICO 2015–2025: free cash flow (above the line) and capital spending (below), in $ millions.
This is the power of economic goodwill at work, and the hallmark of a capital-efficient business: one where sales and profits grow disproportionately to the capital spent on them. As a result, the cash flow available to return to shareholders grows, both in dollars and as a share of sales.
Next: why return on capital, more than growth, decides what a business is worth over ten years.
The series so far
- Part 1: The whole idea, in one line
- Part 2: Same five years, very different businesses
- Part 3: From great business to great investment
- Part 4: Where stock returns actually come from
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This is my personal investing journal, written for information only. It is not investment advice or a recommendation to buy or sell any security, and it does not take account of your circumstances. I may own shares in companies I write about. Past returns are no guide to future returns.
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