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Hellman and Friedman
Hellman & Friedman looked back after its first 10 years in business at the early investing it had done, which had been generally good but somewhat mixed. By working backward from the results, it landed on capital efficiency, return on tangible capital specifically, as a key metric.
TA Associates
TA Associates ran a similar review in the mid-1990s of everything it had invested in going back to the late 1960s. The record was very good but somewhat mixed in how it had been arrived at. Its analysis found growth, and market growth specifically, as a very common thread in its best investing, and it was significantly underrepresented in its more challenging investments.
Housatonic's first eight
A young investor starting his own firm, Housatonic, adopted those learnings early on, return on tangible capital among them. Looking at its first eight investments, he would today invest again in at least six and maybe seven of those companies.
Why does return on tangible capital matter?
It compares profit with the physical assets and working capital a business needs, leaving out goodwill from past acquisitions. A business with a high return needs little new capital to grow, so most of its profit can be paid out or reinvested elsewhere. A business with a low return must keep pouring money into assets just to expand. Goodwill is the premium an acquirer pays over the book value of assets, and it is recorded on the acquirer's balance sheet.
Why would market growth predict good investments?
A company in a rapidly growing market can expand its sales without taking customers from rivals, which eases the pressure to cut prices. As earnings rise, the business becomes worth more even if the multiple paid for it stays the same. Earnings that double in a growing market double the value of the business at a constant multiple.
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