“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.” ~ W. Somerset Maugham – English dramatist & novelist (1874-1965)
As I’ve seen in the past 20+ years of investing in the stock market, Maugham’s thought holds a great relevance when it comes to picking up businesses for investment.
Pick up a business with good economics and with good margin of safety, and the probability of making money in the long run is high. Pick up a business with poor economics with any margin of safety, and the probability of losing your shirt, and entire wardrobe, in the long run is very high.
Understanding a business also adds significantly to your margin of safety, which is a great tool to protect yourself against losing a lot of money.
Here is what Warren Buffett wrote in his 1997 letter to shareholders…
If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.
If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.
Buffett’s investment approach combines qualitative understanding of the business and its management (as taught by Philip Fisher) and a quantitative understanding of price and value (as taught by Ben Graham). He once said, “I’m 15 percent Fisher and 85 percent Benjamin Graham.”
That remark has been widely quoted, but it is important to remember that it was made in 1969. In the intervening years, Buffett has made a gradual but definite shift toward Fisher’s philosophy of buying a select few good businesses and owning those businesses for several years. If he were to make a similar statement today, the balance would come pretty close to 50:50.
Anyways, any discussion on Buffett’s focus on understanding businesses must start with how he defined various businesses as per their economics. And that’s exactly what I’ll try to do now.
Businesses are Great, or Good, or Gruesome Buffett created three broad categories of business, which he first defined in his 2007 letter to shareholders. He wrote that either a business is great, or good, or gruesome.
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%.
When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases.
It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.
Buffett grouped businesses into three general categories – great, good, and gruesome – based on their return on investment profile, and explained the differences between these categories.
I find what follows below as a great mental model while assessing businesses. And the characteristics that Buffett defined to distinguish between these three categories form an important part of my investment checklist.
First, the Great Business Buffett wrote in his letter…
A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success.
Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Now, while most investors search for companies that have had certain competitive advantages or moats that have helped them do well in the past, or they are doing better than competitors in the present. But Buffett here is not just talking about the moat of a business, but in the endurance or sustainability of that moat.
Look at a market like India. We have had several companies doing great business at specific points in their lifetime, but have fallen from grace over years, and are now just a pale shadow of their glorious past.
Whatever reasons there may be for the disappearance of moats for these companies – competition, change in industry structure, capital misallocation – the point is that all companies go through a lifecycle, from birth till stagnation or death.
To quote Horace, “Many shall be restored that now are fallen, and many shall fall that now are in honor.”
There are only handful that survive more than a few decades. You won’t find many such companies in a rapid growth market like India, where entrepreneurial spirit is high and any high-return business will attract competitors sooner than later, thereby lowering the average returns for all players over time.
Thus, the idea must be to look for companies that can survive and thrive at least over the next 20 years – businesses that have…
- Great brands, and where consumers are willing to pay higher prices for the perceived higher value;
- Low cost of operations, which enables them to lower prices and still maintain good margins;
- Operate in simple and growing industries;
- Clean balance sheets that provide them the capacity to suffer bad times; and
- Managements with history of making rational capital allocation decisions.
Here is what Buffett writes on enduring moats…
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Now, while the management quality must be of great importance for you while picking your businesses, Buffett says the quality of the business is paramount. As he wrote…
…this criterion (of identifying businesses with “enduring” moats) eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great.
A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.
Now, while “growth” rules the roost when investors are searching for businesses to invest in, Buffett has a different take on this. Stability – in industry, business economics, earnings, and growth – is more important for him, than just growth.
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere.
A Great Business is an Economic Franchise Buffett terms a great business as an “economic franchise”, and believes that it arises in a business that sells a product or service that:
- Is needed or desired (continuous and rising demand)
- Is thought by its customers to have no close substitute (customer goodwill is much better than accounting goodwill, and allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price)
- Is not subject to price regulation (price maker)
Here is what he wrote in his 1991 letter…
The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.
Moreover, franchises can tolerate (short-term) mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.
A business that is not a franchise, writes Buffett, can be killed by poor management.
In effect, what Buffett seemingly meant was that since a bad management cannot permanently dent the prospects of an economic franchise (except due to long-term mis-management), any stock market downturn provides a great opportunity for investors to consider such businesses (that may also fall in tandem with the markets) for investment.
You must, however, be very careful confirming that a business is a franchise. After all, there’s many a slip twixt the cup and the lip.
Should You Buy and Forget Franchises? Not really, Buffett thinks. He wrote in his 2007 letter…
There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.
In other words, while it pays to pay up for quality businesses please avoid overpaying for them expecting to keep earning money from these stocks the way you or others may have earned from them in the past.
Trees, after all, don’t grow to the sky. And to repeat Horace – “…many shall fall that now are in honor.”
Buffett’s Other References to a Great Business Here are a few other references that Buffett has made over the years in his letters, describing the characteristics of a great business…
- Our acquisition preferences run toward businesses that generate cash, not those that consume it. (1980)
- The best protection against inflation is a great business. Such favored business must have two characteristics: (1) An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. (1981)
- One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. (1983)
- Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. (1996)
- The really great business is one that earns…high returns, a sustainable competitive advantage and obstacles that make it tough for new companies to enter. (2007)
- “Moats”—a metaphor for the superiorities they possess that make life difficult for their competitors. (2007)
- Long-term competitive advantage in a stable industry is what we seek in a business. (2007)
- The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. (2009)
Your “Great Business” Checklist You can use the above points to create your checklist for identifying the great businesses out there.
Alternatively, and an even better way, would be to invert the points and then avoid businesses that are not great. This, I believe would be an easier task, given the enormous number of “Roman Candles” out there – companies whose moats are illusory and will soon be crossed.
So, if you were to invert Buffett’s points on great businesses, here is how your checklist may look like.
Avoid a business that…
- Consumes more cash than it generates.
- Has managers who boast of certainties and invincibility.
- Earns poor return on capital.
- Operates in an industry where it’s easy for new companies to enter and succeed.
- Operates in an unstable industry (maybe due to technological changes, or government regulations)
- Requires consistent infusion of new investment to grow.
- Doesn’t have an ability to increase prices.
- Isn’t able to accommodate large volume increases in business with only minor additional investment of capital.
Second, the Good Business
Buffett writes that while a great business earns a “great” return on invested capital that creates a moat around itself, a good business earns a “good” return on capital.
So what is the core difference here?
Well, while a great business does not require too much of incremental capital to grow, a good business requires a significant reinvestment of earnings if it is to grow. Thus, with a high level of capital intensity, such a business requires high operating margins in order to obtain reasonable returns on capital, which means that its capacity utilization rates are all-important.
In India, leading companies from the capital goods, automobile and banking sectors will find place in this category. Buffett writes that if measured only by economic returns, such businesses are excellent but not extraordinary businesses.
Broadly, good businesses are ones that…
- Enjoy moderate but steady competitive advantage, which typically arises due to their size and thus economies of scale
- Require good managements at the helm, that can execute the plans well to generate high return on rising invested capital
- Grow at a moderate to high rates, and thus
- Require constant infusion of fresh capital
Third, the Gruesome Business Here is where we are going to spend a lot of time, for a majority of the businesses out there would fall in this category. Buffett wrote in his 2007 letter…
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.
Most asset-heavy or commodity businesses would fall into this category. As Buffett wrote in 1983…
…as they generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
Now the question is – Why do such companies earn low rates of return? Buffett answers in his 1982 letter…
Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles.
What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal.
If…costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.
Now the second question is – So are all companies from such industries to be avoided at all costs?
Buffett says some of such companies do make money, but only if they are low-cost operators. As he wrote in his 1982 letter…
A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent.
In fact, when a company is selling a “commodity” product, or one with similar economic characteristics, being the low-cost producer is a must. What is more, for such companies, having a good management at helm is also very important.
From Buffett’s 1991 letter…
With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.
Such companies can also earn high returns during periods of supply shortages.
When shortages exist…even commodity businesses flourish. (1987)
But such situations usually don’t last long…
One of the ironies of capitalism is that most managers in commodity industries abhor shortage conditions—even though those are the only circumstances permitting them good returns. (1987)
When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success. (1982)
Buffett’s Brush with Gruesome Business For the Buffett we know today – the man who has compounded money at over 20% over the last 60+ years – it may sound surprising but he had a brush with a gruesome business at the very start of his career.
The company was Berkshire Hathaway (Buffett’s present-day investment arm), and the business it was in was textile. Buffett calls it the biggest mistake of his career.
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