Now that you have understood the idea of circle of competence and learnt about generating stock ideas, the next thing that you need to focus on is identifying good businesses.
The problem in front of you is that there are so many different types of businesses even within your circle of competence, how do you learn about them all? How to you simplify all this? How do you look at businesses personally?
As always, Buffett simplifies the problem for us. He says there are only three kinds of businesses – the great, the good and the gruesome.
This brings me to a beautiful and a very relevant quote from Maugham who said “It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.”
Once you refuse to accept anything but very best business, the great one, you can save yourself from the clutches of gruesome businesses.
That’s exactly what I’ll try to do in this lesson – which is dedicated to Warren Buffett as you would know below – because knowing the difference between the various types of businesses is one of the most important lessons you must learn in your investing journey.
If you have ever lost money in stocks like Suzlon, DLF, Deccan Chronicle, Kingfisher Airlines, or Manappuram Finance, it was because you did not bother to check the quality of business – whether it was great, good, or gruesome.
In his 2007 letter to shareholders, Warren Buffett wrote …
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.
Let us start with understanding what makes for a ‘great’ business.
The Great Business
To understand great businesses, Buffett uses the term ‘Moat’. Moat is a metaphor for companies having durable competitive advantage. In literal sense, a moat protects a castle from its enemies as shown below.
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.
Buffett is interested not in just the moat of a business, but in the endurance or sustainability of that moat.
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 (as seen from their high and/or industry leading ROE and ROCE)
Now, while “growth” rules the roost when investors are searching for businesses to invest in, stability – in industry, business economics, earnings, and growth – is more important than just growth.
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, wrote Buffett, can be killed by poor management. In effect, what he 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.
Asian Paints and Pidilite industries are two good examples of businesses having economic franchise.
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.
Problem with a gruesome business is that even a good management can’t do much to improve the business returns.
According to Buffett, when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
A gruesome business is not just a terrible investment for you, but also a major distraction that would cost you in terms of opportunity cost.
To sum up Buffett’s description of great, good, and gruesome businesses, here is what he wrote…
…think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
If you have to remember just one thing from this lesson, it must be – Time is the friend of the wonderful business, the enemy of the mediocre. So please pick and choose very carefully.
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