Investment dollars always pursue a return

There is going to be at least one more new grocery store opening in the Twin Cities this week, a gleaming Hy-Vee store in Shakopee.

Grocery shoppers in the area didn't really need another store, of course, this one just a three-minute drive from Cub Foods and Target stores. Hy-Vee's entrance into the market is one reason a consultant this summer called the Twin Cities "one of the most over-stored grocery markets in the country."

And that is saying something. At last count there was more than 4 square feet of grocery retailing space for every person in the country, twice as much as there was 30 years ago.

There seem to be too many restaurants, too, and the New York Times helpfully tried to identify the problem last week as simply "Wall Street."

That is not giving private equity mangers and other people with money nearly enough credit for knowing what they are doing. It is true professional investors have funded a lot of grocery and restaurant projects — but only the ones that would generate a return on their money.

Hy-Vee is owned by its management and employees, and a company spokesperson said it generally expands with the cash generated by operations.

And while this market might have too many stores, you know that if Hy-Vee produced its analysis on the Shakopee store, the spreadsheet would show a solid return on what it cost to build and open.

That means the owners of the Cub down the street have a choice. Keep investing their own capital to defend their market share? That might be a good decision — if they can see a path to earning a good rate of return.

That is business. Allocating capital is as fundamental to owning a successful business as planting in the spring is to Minnesota corn farmers. Small business owners, the best of them anyway, seem to do it in their head.

This is so fundamental that it is worth going over again. The business owner's goal isn't to have money left over after paying the bills. It is to have enough money left over after expenses to also pay for all the capital being used in the business, too.

Capital isn't free. Bank loans cost interest, but the owner's money comes at a big cost, too.

Just like bankers who have choices of whom they want to lend money to, owners have plenty of choices for every dollar they control. And they are restless.

It's curious how poorly understood this seems to be. Around the coffee pot, you may hear grumbling because the company has a lot of cash or maybe the owner seems very rich, so workers should be getting big raises. Really, the owner can easily afford them.

Business simply doesn't work that way. If rising costs for wage increases erode the return on invested capital in the business, it may occur to the owners that they can get a better risk-adjusted rate of return by building an apartment building or even sticking the money in a stock index mutual fund.

That means the smart thing to do is to take money out of the business. So never mind a raise. There could even be layoffs.

Managers of a big company like 3M Co. understand that they have to compete for capital. They understand that they may not go head-to-head for customers with a health insurer like UnitedHealth Group, but they sure compete in the same market for capital.

Making more money after taxes is only one way to increase the rate of return and remain competitive in the market for capital.

Another way is to make the same amount of money while using a lot less capital.

Some industries have shown better returns than others over the long term. The one real head-scratcher, when looking at historical returns on invested capital, isn't grocery retailing but the airline business.

It wasn't until 2015, many decades after Delta Air Lines started carrying passengers, that the airline industry as a whole made enough money in a year to cover the cost of all the capital it deployed, according to the McKinsey & Co. consulting firm.

The decisions about how capital gets deployed also help explain why so many industries are cyclical. A great example is the insurance industry, known for its ups and downs. Over the course of years, the industry will swing from a "soft" market to "hard" market.

In a soft market, insurance rates slip, underwriting standards loosen and there is lots of competition. Why? The industry had too much capital competing for returns, so returns slipped.

You can guess what happens next. With returns down, competitors leave insurance markets, underwriters get a lot pickier about whom they want to insure and prices increase. And eventually returns on capital start to increase.

The same dynamic is at work in the restaurant and grocery industries, too. There has certainly been a lot of new development, and if returns get tougher to come by these industries will attract less capital and development will slow. But you can't say that the people who put money into restaurants didn't know what they were doing.

It is easy to understand why investors liked Buffalo Wild Wings. Its average annual return on invested capital for the last 10 full fiscal years exceeded 15 percent, according to Morningstar, Inc. The most recent returns haven't been quite as good, and that explains how the firm ended up with a determined activist investor demanding changes.

For an example of a far less successful restaurant company, there is no need to look further than a publicly held franchisee of Buffalo Wild Wings restaurants based in Michigan called Diversified Restaurant Holdings. This company's annual return on invested capital over that same 10-year period amounted to only 1.8 ­percent.

Between two options, Buffalo Wild Wings was a far better option for capital. Come to think of it, so was a passbook savings account.

lee.schafer@startribune.com 612-673-4302