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.
