Friday, January 7, 2011

Characteristics of a good business according to Buffett

From reading stuff that Warren Buffett wrote, as well as stuff that other people wrote about Buffett, I think I learned a few things about what makes a good business. The characteristics of a good business are: Able to deploy a lot of incremental capital at good rates of return, throws off lots of cash and do not need to reinvest much of its cash flow to maintain current profitability, and have a wide economic moat. In this article, I will be talking about those 3 characteristics of a good business.

Putting incremental capital to work at good returns

A good business is able to deploy a lot of incremental capital at an above average rate of return for a long time. If a business is able to do that, it will in effect be helping its shareholders compound their money at a good rate of return (the surest path to great wealth) and saving them the trouble of having to invest the extra dividends they would have received if the company didn’t reinvest in its operations (the average investor would, obviously, find it very difficult to achieve results that are similar to a company that can reinvest earnings at above average returns).

To see if a company has been able to earn good returns on incremental capital, I look at the increase in equity and the increase in net profit over a period of time (the timeframe that you use is, of course, up to you, but it should give you a long-term picture). I then divide the increase in net profit by the increase in equity to find the return on incremental capital.

Throws off lots of cash  

A good business shouldn’t need to continually invest a lot of cash just to maintain current profitability, that’s just a recipe for lousy returns. Warren Buffett said on a CNBC interview that his company would be worth $200 billion more had he not bought Berkshire Hathaway and got into the textile business, but bought a good insurance company instead.

Investors should find companies that generate lots of cash, and that don’t need to reinvest a lot of its cash flow at low returns or watch their profits deteriorate, but can instead use the cash to do things like pay out dividends, buy back shares, expand its operations, make acquisitions, and other value creating activities.

The really great businesses earn really great returns, and don’t need much incremental capital to grow their earnings. But because these companies can grow with very little incremental capital, they can’t, for an extended period of time, keep reinvesting a significant amount of its earnings back into their business at the high rates of return they are accustomed to.

If you can get invested in them when they still have a lot of room to grow, then you could potentially have bought a golden ticket to great wealth (assuming that you bought the stock at a sensible price and management is hones and able). But if you can’t, this kind of businesses can still make for very good investments, as you will be able to use the cash that they pay out as dividends to invest in other similar cash cows or even businesses that might not be as attractive, but are still very good in the sense that while they need to invest significantly more money than the great companies to grow, they still earn good returns on equity and can reinvest earnings at above average returns (remember the first characteristic of a good business that we talked about in this article).

To see if a business is able to generate good amounts of cash for their shareholders, and not simply cash that the company has to reinvest in its operations at low returns or face the prospects of declining profitability, I look at the company’s return on assets. But instead of measuring net income against total assets, I divide what Warren Buffett calls “owner earnings” by total assets to get the return on assets figure. Unlike operating cash flow that only takes into account the cash received from operations but not the cash that must be reinvested to maintain the business’ competitive advantage and profitability, owner earnings take into account the capital expenditures necessary to maintain current operations.

The asset-light, great businesses will generate excellent owner earnings in relation to assets, and the lousy, asset-intensive businesses will, of course, generate poor owner earnings in relation to assets.           

Economic moat

A durable competitive advantage is what sets apart the good and great companies from the mediocre and downright lousy companies. A significant competitive advantage allows a company to earn better than average profits or maybe even excellent profits, and protects the company’s profits from competitors that want to get a piece of the action. A strong brand, being the low-cost producer, patents, and having a near monopoly over a certain market are some sources of competitive advantage.

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.