One of the great tragedies in life is that most people forget what it is they set out to accomplish.  In business, this phenomenon manifests itself most often as a man or woman who starts their own company to gain financial independence and control over their time only to find himself slavishly devoted to growing his small business, working more hours than he ever did for an employer.

This is often the result of a common mistake committed by both small businesses and giant corporations alike: the romanticizing of sales.  Dreams of larger factories, bigger machines, million-dollar contracts, and offices full of employees serve to intoxicate owners and managers as they forget what it is they set out to do.  Yet, as each new benchmark is reached, the owners find they are generating no more profit than they were several years ago (or, if they are, not enough to justify the hours they are working or the effort they and their spouse have put into the firm).

Instead, the focus should be squarely on generating profits that can be taken out of the business without harming its competitive position (something often referred to as owner earnings, a term coined by Warren Buffett in the 1970′s long before he became a household name).  While this approach seems like common sense, it seems to be the exception, rather than the rule.

An Example of the Sales vs. Profits Conundrum In My Own Life

Nearly ten years ago, when I was a sophomore in college, I had a small online publishing business that was generating somewhere between $35,000 and $50,000 a year for me in sales (I’d have to dig through the office filing cabinets for my tax returns to research the exact amount).  This business was designed for one thing, and one thing only: I wanted to make enough to enjoy college but didn’t want to have to work a regular job.  That’s why it had 90%+ pre-tax profit margins (my only costs were typically a new computer system every year, software, and trade publications such as books and magazines related to the nature of the business).  As I went to class, drank coffee in the dining commons, spent weekends in New York, and played video games, these earnings just kept pouring into my personal brokerage account.  Given that I didn’t spend very much, most of it ended up being used to buy shares of whichever stocks interested me at the time.  I maxed out every retirement account contribution for which I was eligible, paying my own way through a private university.

If I had been like most people, somewhere along the line I would have attempted to drive sales to $500,000, hire people, try to manage them, my course work, my extra-curricular activities, and still enjoy a social life.  I knew that, God willing, I’d have the rest of my life to work and decided against it, knowing that not only would I enjoy my time in school, when graduation came, there should at least be $100,000 sitting in an account with my name on it.  This allowed me to make a quality of life decision that, in the ironic nature of the universe, allowed me to spend most of my waking hours pouring through annual reports, SEC filings, and investment books, learning a craft that would someday make me a multi-millionaire.  It also freed me to take consecutive high-ranking internships at two of the best known companies in the world, working alongside portfolio managers that controlled billions of dollars, watching as they did their job.

A Remnant of the Industrial Revolution

I’m convinced that this emphasis on sales instead of profits is a result of the industrial revolution, where mass production relied upon economies of scale.  In that era, which laid the groundwork for western dominance over the centuries that followed, increased revenue led directly and measurably to higher profits.  Steel barons, oil tycoons, banking magnates, and textile kings raised themselves from nothing to fortunes that had been the domain of kings in times past.

Today, that is no longer the case.  The single most important indicator of growth and profits is return on equity.  Wal-Mart Stores, Inc. is a perfect example.  Using a DuPont analysis of the return on equity figure in the early years, you can see that Sam Walton drove his company to absolute power through a combination of asset turnover, financial leverage (consisting of borrowed money, manager investments in the stores, and vendor financing through a negative cash conversion cycle), and profit margins.  Although his low profit margin strategy gets the most press, it was successful because it worked in harmony with the other two variables in the formula, driving up ROE to breathtaking levels.  Often characterized as a country bumpkin, Walton was a brilliant man who knew this and it was return on equity that guided his decisions.  If you don’t understand what those ratios mean, how can you ever hope to compete?  Give up, throw in the towel, and go back to work.  Otherwise, you’ll lose your shirt.

How We Use This Philosophy at Kennon Green Enterprises

This sales vs. profit philosophy is a cornerstone of our business.  Of one of our first subsidiaries was tiny by most standards, generating roughly $330,000 per year in sales.  Yet, it enjoyed 70%+ gross profit margins and virtually no costs, providing us with $230,000+/- in gross profits to deploy how we saw fit to expand.  We built our office, began pouring $30,000 to $40,000 a year into an online advertising budget, launched expansions to our core business, and out of those decisions, all designed to maximize profits for owners and taxable income, our current holding company emerged.

Today, we are much older, wiser, and knowledgeable about the industries in which our businesses compete.  Our capital allocation philosophies have made all the difference in the strength of our firm, allowing us to experience ever-growing streams of cash for expansion and investment and, we hope someday in the not-to-far future, an initial public offering.