Three common mistakes beginner investors make (#2 of 3)

20 Sept 2023 · 2 min

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1:55

In this segment, the speaker identifies the second common mistake made by beginner investors: assuming that a high gross margin is the primary indicator of a high‑quality business. He argues that this view is overly simplistic because there are multiple routes to achieving a high return on invested capital (ROIC), such as strong capital turnover and robust free cash flow generation. The speaker illustrates the point with Costco, which has a modest 12% gross margin yet delivers mid‑teens ROIC thanks to efficient capital use. He attributes the prevalence of the gross‑margin bias to the dominance of software investors, who favor high gross margins to cushion aggressive R&D and sales spending, and mistakenly apply this standard to all industries. The core message is that investors should evaluate businesses using broader quality metrics—ROIC, free cash flow, and economic profit—rather than relying solely on gross margin percentages.

Chapters

Common mistakes more beginner investors make. The second mistake is not realizing there's multiple ways to get to a high return on invested capital, and a high gross margin is just one of them. There's this idea that high gross margin is like the end-all be-all measure Of the quality of a business. That's obviously wrong. We talked about earlier in this podcast, ROIC, free cash flow, and economic profit are the measures of quality. But there's this idea that if a company doesn't have a high gross margin, 70, 80, 90%, then it's a bad business. Well, then you miss Costco, 12% gross margin. Some of the biggest compounders the world has ever seen, Did not have gross margins above the S&P 500 median or average. And I just mentioned Costco's gross margin is 12%. It's almost in the dirt, but it's an exceptional quality business that generates mid-teens returns on invested capital because of its invested capital turnover. So the second mistake is not realizing there's multiple ways to get to a high return on invested capital. Now I understand why. It's because everyone's a software investor these days, right? And a high gross margin does matter for software. Because they're just investing so recklessly down that income statement. It's better to start off with a really high gross margin if your R&D and your sales and marketing are just going to be reckless. You want to be left with some bottom line profit. So they start with a high gross margin, but then they take that and just translate it over into every business in every industry should have a high gross margin, which is just clearly wrong.