Because the company sees potential. It's not necessarily about what it is, but about what it can be. ARMS was only a modest hit, but Nintendo still sees potential in the IP, and it's sales are enough for Yabuki to continue making ARMS games if he wants. It's only if the franchise refuses to show growth or starts to stagnate that they pull the plug. Nintendo's not a company who kills IP after the first game just because they're not the next Mario. Unless it's made to be an odd-ball oneshot, Nintendo is willing to give lesser selling games a fair chance at sustaining on their own, only killing a series after a string poor sales. Fire Emblem Awakening was threatened to be the last game in the series if it didn't succeed. But Intelligent Systems was able to make it the most successful Fire Emblem game in years. And guess what, Fire Emblem sells roughly on par with ARMS, only peaking around 2-3 million per game if we go by modern entries. But it's enough for Nintendo to now consider it a major player in their staple of IP. ARMS will likely be the same, it may not reach the highs of Mario Kart, but if it can sustain 2-3 million sales per game and maybe even more, then Nintendo will be pleased. 

Yes, Nintendo relies a lot on collaborations to fill out a yearly release calandar. In the US alone, the publish around 25-30 games each year. That's more than most publishers put out in an entire generation. Yet even before the Wii U, Nintendo's internal teams (IE, EAD and SPD) only ever put out around 4-5, maybe 6 games each year. That's still impressive, but it's only a fraction of their total yearly output. 

If we were talking about committing a secondary or external studio to it I'd say sure, go for it. 3 million is a good outcome if you're Monolith Soft, ND Cube, or Intelligent Systems. But for the team that make Mario Kart, an ARMS sequel just isn't worth the investment. It'd be like committing Naughty Dog to make Knack 3 instead of Last of Us Part 2. As an IP, ARMS has demonstrated a distinct lack of longevity, and for the same amount of resources  as a sequel would need, you could've created a breakout new success or a new entry in a flagship property that could top 10 million.

And again, Nintendo doesn't put it's teams on a pedestal like that, especially since EPD teams are more decentralized than most studios. I mean, Mario Kart 8 Deluxe is still selling Switches and is even getting a few updates, so it's not like Yabuki and the team are in any rush to get a new Mario Kart on the Switch. Thus, Nintendo is fine with them concentrating on ARMS for now, and maybe making Mario Kart 9 sometime in 2021 or something. It's not about ARMS being the next Mario Kart, it's about providing a solid and successful foundation to build on for the future. 

It's not a matter of pedestals, just of ROI. From a business point of view, it's simply unwise to invest heavily in a series whose debut entry is dead in both sales and mindshare within a year of its release.

Yes, it seems that way if you're looking at it from a cynical EA or Capcom perspective. But Nintendo has different standards for success than most game companies. True, the likes of Mario and Smash are expected to sell the biggest. But Nintendo typically is very conservative with sales estimates for most of their games. Splatoon was not anticipated to become the breakout phenomenon that it eventually ended up as. Splatoon 2 still would've been made by the original team anyway if it managed to pull 2 or 3  million copies, that would've been enough for Nintendo to consider it worth keeping around. But it not only shattered those expectations, but it shattered them to the point where getting a sequel onto the Switch ASAP was top priority for Nintendo. 

I'm sure Nintendo had even more conservative expectations for ARMS. It's a genre that's more niche than Splatoon, but it still sold more than most modern fighting games. That's good enough for them. It doesn't matter if it came from the Mario Kart team, Zelda team or what not. It Yabuki wants a sequel, then Nintendo will likely let him make a sequel. 

I'm simply looking at it from a logical business point of view. Gaming is a business.

Any competent management will look at how rapidly ARMS slipped from the charts and the public eye and see sinking resources into a successor as a poor investment. The only way it can happen if it Nintendo's execs are bad at their jobs.

Yes gaming is a business, but a business can be okay with modest success. Not everything needs to be the next mega hit phenomenon. Nintendo again, doesn't play by typical gaming executive rules. Nintendo values success not just on how much money or sales it made, but on how much players enjoyed the game. ARMS may not have had the shelf life of some of the Switch's other titles, but it still sold quite well for its first year, and still retains a healthy player-base. Nintendo still somewhat supports the game as well with regular party crash events, they even celebrated its one year anniversary. It's obvious they don't consider ARMS a failure. 

And I don't think green-lighting a sequel means Takahashi (head of EPD) is bad at his job. If anything, it shows he's willing to take creative risks, letting a property sustain itself or grow, and won't just kill a series just because it's not the next Splatoon or something. 

At the end of the day though, Nintendo's lead teams exist to drive their hardware and software business, and ARMS 2 doesn't really achieve either objective. There is a place for the modest success, but that place isn't one of Nintendo's flagship teams.

But as I mentioned, Yabuki already got out a title that can drive hardware sales. Mario Kart 8 Deluxe. It's outselling the Wii U version, and is still a system seller for the Switch. Nintendo's not in any rush for Yabuki to be working on a new Mario Kart with 8DX selling so well. The team can focus on ARMS for now because that's a new property that's still successful and helps diversify the Switch lineup. It's not bad business I believe. 

But it makes little sense to double down on ARMS when they could still diversify the lineup and achieve much better hardware and software sales through other projects. There's a long list of potential games the team could undertake next, why limit themselves to an IP they already know isn't a heavy hitter?