At the annual meeting in 1996, Warren Buffett and Charlie Munger commented that, “If you find three wonderful businesses in your life, you’ll get very rich.” At the meeting one year later, he said, “The single biggest recurring mistake I’ve made has been my reluctance to pay up for outstanding businesses.” As a new investor, you may here this and wonder, “Yes, Joshua, but what is it that actually makes a company an excellent business?”
To help you understand the traits of an excellent business, I’ve put together some resources that will give you an idea of what you should look for in a stock, and, just as vital, why it is important. Armed with this information, over time you’ll be more likely to build a portfolio of wealth creating assets that can provide financial security for you and your family.
An excellent business earns high returns on capital with little or no debt
There seems to be little doubt, based upon the evidence, that it’s easier to build a large net worth through value investing – that is, the disciplined purchase of stocks, bonds, mutual funds, and other assets that appear to be selling at a substantial discount to a reasonable person’s estimate of intrinsic value (or “the real” value.) Think of it as if you knew a local car wash had gold buried underneath it. The proprietor might be asking $800,000 for the land and enterprise, but you know full well that you could pay substantially more, not only owning the business, but also selling the gold you dug up on the open market. Thus, you had reason to believe that it was being sold for far less than its intrinsic value.
The one major shortcoming of this approach is that an asset bought cheap must be sold when it reaches intrinsic value unless it is an excellent business. As Charlie Munger has pointed out, over long periods of time, the rate of return which an investor earns is likely to be very close to the total return on capital generated by a firm, adjusted for dilution in shares outstanding. Thus, you are likely to do better paying fair value for a business that can reinvest its capital at high rates of return – say, over 15% to 20% per annum – than buying a mediocre business trading at a small discount to its liquidation value.
For more information, read Business Like Investing: Thinking Like an Owner; on the second page of the article you’ll find information on why return on capital matters.
An excellent business has durable competitive advantages
If you had unlimited funds, do you really believe that with the best pick of any manager in the world, you could unseat Coca-Cola as the undisputed leader in the soft drink industry? How about Johnson & Johnson with its myriad of patents, trademarks, and brand name products? The reason these businesses are able to succeed so well is that they have durable competitive advantages – things that their competitors can’t reproduce.
Sometimes these advantages are easy to spot – as is the case of Coca-Cola, which is the second most recognized word on Earth. However, it is possible for them to remain buried. One of the secrets to the phenomenal success of Wal-Mart is that Sam Walton built a distribution system with logistical capabilities that allowed him to lower the transportation costs of moving merchandise to his stores, allowing him to make far more profit than competitors selling at higher prices. He and his fellow shareholders won from the increased income while consumers won from the lower prices. These forces worked in combination with one another, reinforcing and accelerating the results so much that the tiny five-and-dime grew into the largest retailer the world has ever seen.
When you buy into a company through the purchase of its common stock, try to identify the durable competitive advantages it has that could stand up from attack by competitors and market forces such as outsourcing and increased globalization.
An excellent business is scalable
When businesses are highly successful, one of the key ingredients more often than not is scalability. Take American Eagle Outfitters, which has one of the best long-term investment records over the past decade. Why was it successful? Target? Wal-Mart? McDonald’s? Coca-Cola? Pepsi? Microsoft? All are excellent businesses in part because they had products or services that could be replicated in cookie-cutter fashion very, very rapidly.
Think about it. The McDonald’s in Hong Kong is very much like the McDonald’s in Chicago. And New York. And Southern California. By having the menu, layout, fixtures, and technology packaged in a way that restaurants could be rapidly opened, it made it easier for the chain to roll out across the United States and world. Coupled with its relatively high returns on equity and the cash provided by the franchisees, which footed the bill to build a huge portion of the overall business, it’s not hard to see why the shareholders might consider Ray Kroc as a hero.
The price still matters …
For those of you too young to remember the Nifty Fifty, this idea of buying excellent businesses was taken to such ridiculous extremes in the 1960’s that investors paid upwards of sixty and seventy times earnings! To contrast, a normal price-to-earnings ratio on Wall Street is considered fifteen; that is, for every $1 in per share profit a company generates, it would trade for $15. It didn’t take a genius to see that even if the business was all it was cracked up to be, at those prices, it would be virtually impossible to earn a satisfactory long-term rate of return.
That’s why you need to take a moment to read Price is Paramount to see an illustration of how lower growth rates can actually lead to higher rates of return in certain circumstances.
Buy and Holding Investing Strategy
Although I actively manage my regular investment accounts, and as you know, there are several businesses in which I am involved, one strategy that I use for one of my personal IRA accounts is to select only one business each year that has durable competitive advantages, earns high returns on equity, boasts talented management, has a history of disciplined capital allocation including returning excess capital to owners in the form of cash dividends and share repurchases, and the potential for future growth where I can be reasonably sure that earnings are likely to be materially higher in five or ten years. I then use the entire annual contribution limited to acquire as many shares as possible, instruct my brokerage firm to reinvest all dividends, and practically forget about the holding altogether. At least once a year, I’ll review the company’s progress and results to make sure there aren’t material changes in the underlying quality of the enterprise. For the most part, regardless of market conditions, I simply forget these equities exist.
Why, do you ask, would I be inclined to do this when my regular investing results are so good? It’s simple: Insurance against ignorance and overconfidence, as Benjamin Graham called it. There’s no way I can possibly know everything, and as evidenced by the impressive work of Professor Jeremy Siegel, excellent businesses with reinvested dividends over several decades have crushed the broader market. One well-known financial news and commentary company points out in an online product description that only $2,000 invested in Pepsico 25 years ago has now grown to over $150,000; a single share of Coca-Cola bought for $19 with dividends reinvested in 1919 would now be worth more than $5,000,000+. Through market highs, lows, and in-between, these great businesses just keep on compounding. By owning a collection of them, in a retirement account, outside of the realm of my enterprising endeavors, businesses, and active investment portfolio, it’s a quiet reminder to manage my affairs conservatively (as would an insurance company that guards against a 1 in a 1,000 year storm) and let the companies themselves do the heavy lifting. It is also my hope to someday use the account as a sort of living, breathing didactic exercise to prove the merits of compounding to my children, grandchildren, and even – dare I say it – great grand-children.
In ways, it’s comparable to what Anne Scheiber did when she amassed a $22+ million fortune from her tiny New York apartment. By selecting value priced, blue chip stocks, the frictional expenses of active management, frequent big / ask spreads, commissions, and taxes are all greatly reduced, leading to more capital compounding for the investor. As Charlie Munger pointed out, by holdings stocks for long periods of time and paying only a single 35% tax at the end (these rates were before the Bush cuts on capital gains), a 15% return would by upwards of 13% by the time it is all done – compared to much, much less – 10% or 11% depending on the circumstances – if the money were made by frequent trading. Over a 50 year time period, a small 3% advantage can result in triple the wealth. You read that right. As one great investor said, this is a game of inches, not of feet and yards. You make the best decisions you can and over time, they amount to something meaningful.
How can you go about choosing which stocks should make the cut? Believe it or not, you shouldn’t just go with the cheapest or most undervalued company. That’s because over long periods of time, a stock is likely to compound at the rate the underlying business earns on shareholder equity. That is, provided you’ve paid a reasonable price (remember – Price is Paramount), and Wall Street maintains a consistent valuations as measured by the price-to-earnings ratio, a company earning 13% on shareholder equity will probably compound at that same rate, with dividends reinvested, provided it is held in a tax-advantaged account. Given a ten year or longer time span, you’d be better off owning this business than one earning 8% on shareholder equity but trading at a 30% discount to intrinsic value.