What makes a great business?
A checklist of questions to consider when looking at businesses to determine if they are good investments. Inspired by the teachings of Warren Buffett and Charlie Munger from Berkshire Hathaway.
“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” —
Warren Buffett, Berkshire Shareholder Meeting, 2003
Warren Buffett is the chairman and CEO of Berkshire Hathaway. Largely considered the world’s greatest investor, he and his Berkshire business partner, Charlie Munger have grown the company’s per-share book value from $19.46 in 1964 to over $225,000 in 2019 (a rate of over 18.9% compounded annually over 54 years).
They have invested in everything from Coca-Cola to Heinz ketchup to Gillette to insurance companies, media companies, railroads, real estate and many more.
This article is my attempt to document the teachings of Warren and Charlie into a decision-making process and checklist for future reference. Inspired by a collection of books, shareholder letters, and shareholder meeting Q&A videos on Berkshire Hathaway, Charlie Munger, Ben Graham, Philip A. Fisher and many more.
This article builds upon the thinking and core principles I adopted from Ben Graham’s ‘The Intelligent Investor’ and Philip Fisher’s ‘Common stocks and uncommon profits’.
The Intelligent Investor
The 3 core ideas I absorbed from the book are as follows:
- Think like a businessman inquiring into the value of the whole business: A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business. Think of oneself as a private businessman inquiring into a business while the market capitalization represents the entire price paid for the business.
- Mr. Market: Mr. Market was the metaphor Graham used to describe the market and explain how stocks can become mispriced. Mr. Market often lets his enthusiasm or his fears run away with him.
- The margin of safety: No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the “margin of safety” — never overpaying, no matter how exciting an investment seems to be — can you minimize your odds of error.
If you’d to know more on ‘The Intelligent Investor’ be sure to check out my article on Ben Graham’s book here.
Common Stocks and Uncommon Profits
Philip A. Fisher lays out 15 points for picking outstanding companies. They are as follows:
- Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
- How effective are the company’s research and development efforts in relation to its size?
- Does the company have an above-average sales organization?
- Does the company have a worthwhile profit margin?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations?
- Does the company have outstanding executive relations?
- Does the company have a depth to its management?
- How good are the company’s cost analysis and accounting controls?
- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
- Does the company have a short-range or long-range outlook in regard to profits?
- In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
- Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
- Does the company have a management of unquestionable integrity?
So how do we build upon the principles above to determine the next criteria for determining an investment?
1. Deal with a business you can understand clearly
“You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” — Warren Buffett
So what is defined by your circle of competence? Let’s look at the following
- Do you clearly understand the business and it’s underlying economics?
- Do you understand the industry and its major players?
You define a circle of competence, areas of business you have paid close attention to and understand clearly.
You want to be honest with what you can clearly understand and stay within it. This way you can avoid making mistakes like venturing out into types of businesses and industries that you don’t fully understand, where someone else has an edge over what you know.
2. How do you determine the durable competitive advantage of the business?
“Frequently, you’ll look at a business having fabulous results. And the question is, “How long can this continue?” Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now — and then to figure out the forces that could cause those results to stop occurring” — Charlie Munger
Here are a few ways to understand the intrinsic characteristics that give a business a durable competitive advantage.
Scuttlebutt
Philip A. Fisher used the term ‘Scuttlebutt’, saying that qualitative factors like the ability to maintain sales growth, good management, research, and development characterized a good investment.
The 15 points discussed above is a great place to start. These are qualities we should be searching for in great businesses. Fisher’s proof that these factors could be used to assess a stock’s long-term potential is a great place to begin.
The ‘moat’ around the castle
Imagine a business is a castle, you want an impenetrable wall and moat protecting the castle. The people who want to penetrate the castle walls would be your competition.
Coca-Cola, Gillette, and other businesses like See’s Candies, have a huge “moat” around its brand invulnerable to the competition. Their brands give each of them a durable competitive advantage.
While there are moats that include brands, a brand is not a moat. The moat is whatever qualities are innate to the business that makes it difficult to compete with.
Additionally, we can ask ourselves the following questions to explore the topic further.
- What does this business’s long term economics look like and how does it maintain market share over time?
- Can a competitor with a billion dollars just come over and take its market share?
3. Is there great management in place?
“Find a business any idiot could run because eventually one will” — Peter Lynch
Able and trustworthy management is a rare find. Warren and Charlie have placed a large emphasis on exceptional management, and consider it one of the major characteristics they look into when evaluating a business.
Once again, we can look at some of the points addressed in Philip A. Fisher's checklist.
- Does management have integrity and talent?
- Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
4. What is the price that you pay for the business?
“No matter how wonderful a business is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.” — Charlie Munger
To understand the context of this question we need to look at what interest rates look like at the time along with the short term and long term government bond or government-backed fixed deposit rates.
The economic value of any asset, is the present value of the appropriate interest rate, of all the future streams of cash going in or out of the business. You need to have some idea of what the stream of cash will be over the next 10 — 20 years.
Look at the current and historical rates of return generated by the business. Building upon a core Ben Graham principle, we adopt the mindset of a private businessman inquiring into the sale of a whole business outright. We compare those rates of return against the price paid for the whole business — the entire current market capitalization at the time.
- What have the post-tax and pre-tax rates of return looked like over the last 6–10 years? Can we expect similar rates of return looking forward 5–10 years into the future?
- What do these rates of return look like compared to a long term risk-free government bond or government-backed fixed deposit?
Eg. NDB Bank PLC fell to Rs. 93.00 a share on the 22nd of March 2019. If I was to buy the whole business outright, I would pay Rs. 20 Billion for all shares of the company (this figure represents its entire current market capitalization — 10th May 2019). For the year 2018, the company generated a profit of Rs. 5.5 Billion attributable to shareholders (source — NDB Annual Report 2018).
That is roughly a 27% return on investment by the business. A government-backed 1 year fixed deposit had an interest rate of 10.55% in 2018.
5. What is your margin of safety?
“We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than it’s price, we’re not interested in buying. We believe this margin of safety principle, emphasized by Ben Graham, to be the cornerstone of investment success” — Warren Buffett
No matter how optimistic the market feels about the future of certain businesses or the economy an investor must never compromise on a ‘margin of safety’ and leave out the possibility of being wrong.
- Only by insisting on what Graham called the “margin of safety” — never overpaying, no matter how exciting an investment seems to be — can you minimize your odds of error.
The margin of safety is the average earnings power (inverse P/E ratio) of a business taken against a 1–5 year Government backed fixed deposit rate (10.55%) in 2018 or against the 2018 Sri Lanka bond yield (10.8%) for 1 year in 2018
Conclusion
I can sum up what a great business is with one of my favorite Buffett quotes from the 2003 shareholder meeting.
“So if you had your choice, if you could put a hundred million dollars into a business that earns twenty percent on that capital — twenty million — ideally, it would be able to earn twenty percent on a hundred twenty million the following year and on a hundred forty-four million the following year and so on. You could keep redeploying capital at [those] same returns over time. But there are very, very, very few businesses like that … we can move that money around from those businesses to buy more businesses.” —
Warren Buffett, Berkshire Shareholder Meeting, 2003
References
This article was derived in large part by the influence and inspiration listed below.
- The Snowball: Warren Buffett and the Business of Life — Amazon
- University of Berkshire Hathaway: 30 Years of Lessons Learned from Warren Buffett & Charlie Munger at the Annual Shareholders Meeting — Amazon
Check out my personal page
If you enjoyed what you read here, be sure to check out my checklist on the psychology of human misjudgment, inspired by the wit and wisdom of Charlie Munger here.
Additionally, you check out my article on Ben Graham’s ‘The Intelligent Investor’ here or my review of Adam Smith’s ‘Wealth of Nations’ here.
You can find me on LinkedIn or contact me at https://www.chrisquyn.com/contact/
