Wit, Wisdom, Warren (Issue #9): The Great Business

“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)

Maugham’s thought holds a great relevance when it comes to picking up businesses for investment. So, the results of your investing efforts are decided not after you make or lose money in 5-10 years, but at the very moment you decide to own a specific business.

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 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 Buffett 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.

In today’s post, I look at Buffett’s definition of the “great” business, which he first explained in detail in his 2007 letter….and will cover the good and gruesome business characteristics in subsequent posts.

The Great Business
Buffett wrote in his 2007 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 is interested not in 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.

A few names that come to mind instantly are that of Bharat Forge, Indian Hotels, Tata Steel, and Hero Motocorp. These companies boasted of moats at some point in their lives, but have lost them as years have passed.

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 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;
• Operate in simple and growing industries;
• Clean balance sheets; and
• Managements with history of making rational capital allocation decisions

This choice has to be made NOW, not AFTER you lose money in businesses that have all these characteristics missing.

Anyways, 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:

1. Is needed or desired (continuous and rising demand)
2. 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)
3. 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 – franchises like Nestle, HUL, Titan, or Asian Paints – 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.

I must 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.

Sounds doable?

Let me know your view on Buffett’s thoughts on great businesses, how has been you experience with such businesses in the past, and any incremental views from other successful investors you may want to add here.

I will cover Buffett’s views on “good” and “gruesome” businesses in the subsequent posts.

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