How to identify great businesses according to Warren Buffett

In 1976 Benjamin Graham asked Warren Buffett to coauthor a revised edition of The Intelligent Investor. They corresponded, but Buffett found that he and his teacher had some basic disagreements. Buffett wanted a section on how to identify “great businesses”. Graham didn’t think the average reader could do it and the idea eventually fell through. That’s why in this video I’m trying to answer the important question of what constitutes a great business.

High rates of return

According to Buffett the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.

Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

High margin Business

The best results occur at companies that require minimal assets to conduct high-margin businessesand offer goods or services that will expand their sales volume with only minor needs for additional capital. Good example for such a business is Google.

Habit forming Businesses

During the 1987’s Berkshire annual shareholder meeting Buffett said that “the Ideal Business is something that costs a penny, sells for a dollar and is habit forming”.

Business castles with moat – durable competitive advantage

The moat represents a barrier to competition and could be low production cost, a trademark, or an advantage of scale or technology.

Buffett says that what really matters is the “moat” around the business. The greater the moat, the greater the certainty and amount of future cash flows.

The key dangers relate to:

  • change in market share
  • change in unit demand and
  • the capital allocation skills of management.

The bigger the moat, the less great management is needed. As Peter Lynch has said, “Find a business any idiot could run because eventually one will.”

Buffett regards Wrigley’s and Coca-Cola as businesses with wide moats.

Munger said the ideal business has a wide and long-lasting moat around a terrific castle with an honest lord.

Always Coca-Cola – Share of Market and Share of Mind

The key according to Buffett is share of market and “share of mind.” “If share of mind exists, the market will follow.”

They regard Coca-Cola as the standard. Its share of mind with the world’s six billion people is remarkable. Even the container is identifiable.

Coca-Cola’s market share is marvellous, and its share of mind is overwhelmingly favourable with a ubiquity of good feeling.

Buffett concluded that it’s hard to think of a better business in the world. There may be companies that could grow faster, but none as solid.

Unregulated Toll Bridges

“Warren likens owning a monopoly or market-dominant company to owning an unregulated toll bridge. You have the power to increase rates when you want and as much as you want.”

Buffett had fancied toll-booths ever since, as a boy, he had gazed at the traffic cruising past his friend Bob Russel’s house. Buffett controlled a quarter of a real toll bridge – the only one owned by stockholders in the United States. It was the Ambassador bridge between Detroit and Windsor, across Lake Erie from Buffalo.

Business where you have to be smart once

Buffett noted it is important to differentiate between a business where you have to be smart once (like Coke) versus one where you have to stay smart (like Intel). For example, in retail, you are under assault at all times versus Coke or Wrigley’s, where you just need to be first.

If the competitive advantage is the result of some technological advancement, there is always a threat that newer technology will replace it. Today’s competitive advantage may end up becoming tomorrow’s obsolescence. If Intel doesn’t invent new processors it will lose its competitive advantage within just a few years.

For Warren Buffett companies that have to spend heavily on research & development have an inherent flaw in their competitive advantage that will always put their long-term economics at risk, which means they are not a sure thing.

Moody’s, the bond rating company, is a long-time Warren’s favourite, with good reason. Moody’s has no R&D expense.

Low-Risk Business with Moat and a Low Debt

Overall, Buffett seeks low-risk businesses with sustainable, durable competitive advantage and strong capital structures.


Letters to shareholders of Berkshire Hathaway – Warren Buffett

Warren Buffett and the Interpretation on Financial Statements – Mary Buffett & David Clark

Roger Lowenstein – Buffett – The Making of an American Capitalist

University of Berkshire Hathaway – Daniel Pecaut, Cory Wrenn


IPO Investing overview

Do you think you can make lots of money by getting in on the ground floor of the initial public offering of a company just coming to market?

IPO stands for Initial Public Offering – it’s the first sale of a new issue of company’s stock to the public.

Only when we purchase shares at an IPO we are providing capital for:

  • the acquisition of personnel,
  • plant,
  • and equipment.

Only then are we truly investing. Most of the time, we are buying and selling shares in the “secondary market”; the company usually has no interest in the flow of funds, since such activity does not directly impact it.

Warren Buffett believes that an intelligent investor in common stocks will do better in the secondary market than he will do buying new issues.

The reason has to do with the way prices are set in each instanceThe secondary market, which is periodically ruled by mass folly, is constantly setting a “clearing” price.  No matter how foolish that price may be, it’s what counts for the holder of a stock or bond who needs (forced sellers) or wishes to sell. There are always going to be a few such holders at any moment.  In many instances, shares worth x in business value have sold in the market for 1/2x or less.

Good illustration to that point is the bear market of 1974-1975. By the end of 1974, the average stock sold at seven times earnings (average P/E = 7).

Buffett says that the new-issue (IPO) market, on the other hand, is ruled by controlling stockholders (insiders) and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether.  Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction:  It’s rare you’ll find x for 1/2x here.  Indeed, in the case of common-stock offerings, selling shareholders are often motivated to unload only when they feel the market is overpaying.

Remember that the major sellers of the stock of IPOs are the managers of the companies themselves. They try to time their sales to coincide with a peak in the prosperity of their companies or with the height of investor enthusiasm. In such cases, the urge to get on the bandwagon – even in high-growth industries – produced a profitless prosperity for investors.

Buffett recommends to avoid new issues – the insiders are selling their company, so it’s ridiculous to think that an IPO will be the cheapest thing to buy in a world of thousands of stocks. The IPO sellers pick the time to sell. So don’t waste five seconds on it.

Most new issues are sold under “favorable market conditions” – which means favorable for the seller and consequently less favorable for the buyer. Academic research has shown that corporations choose to offer new shares to the public when the stock market is near a peak. There is a general tendency to sell new securities of all types when conditions are most favorable to the issuer.

There are supply limitations on a hot IPO market.

The typical IPO buyer looks for a short-term price spurt arising from a combination of hype and scarcity. Buffett noted that on many initial public offerings, Wall Street firms intentionally limit supply, so the stock has a big first-day pop, creating a “hot issue”. However, that just means Wall Street’s favorite clients (IPO underwriters), not the company, are getting the enormous benefits of a hot IPO market.

There is also a Build-in commission of 7% on average.

New issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. IPOs normally are sold with an “underwriting discount” which is a built-in commission of 7% on average.

Charlie Munger said to avoid issues with a large commission attached. Instead, look at things other smart people are buying. Like for example businesses that top value investors are buying into.

The poor performance of IPO companies starts about six months after the issue is sold. Six months is generally set as the “lock-up” (or escrow) period, where insiders are prohibited from selling stock to the public. Once that constraint is lifted, the price of the stock often tanks.

All the reasons mentioned above come down to IPOs being very expensive.

IPOs flagrantly violate one of Benjamin Graham’s most fundamental investing rules, namely:

No matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.

Why people gravitate toward buying an IPO?

In fact, one of the deadliest investment traits is the need for excitement. People gravitate towards low-probability and high-payoff bets. For example, it’s well known among professional horse race bettors that it is much easier to make money on favorites than on long shots. The reason is that the amateurs tend to prefer long shots, making the odds for the remaining favorites more advantageous than they should be. It is much more exciting to bet at fifty-to-one than at two-to-five.

On more obvious level, why does anyone buy a lottery ticket when the average payoff is about fifty cents on a dollar? The same thing happens in the investment world, where small, long shot companies attract too much capital, leaving less capital for duller, more established companies. This depresses the prices of the more established companies and increases their returns.


Some of these issues may prove excellent buys – a few years later, when nobody wants them, and they can be had at small fraction of their true worth.

If the prospects for a given IPO are so phenomenal, then it will be a fine investment next year and the year after that. Why not put off buying the stock until later, when the company has established a record? Wait for the earnings. You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.

Often with the exciting long shots the pressure builds to buy at the initial public offering or else you’re too late. This is rarely true, although there are some cases where the early buying surge brings fantastic profits in a single day.

IPOs of brand-new enterprises are very risky because there’s so little to go on.

Peter Lynch has done better with IPOs of companies that have been spun out of other companies, or in related situations where the new entity actually has a track record. These were established businesses already, and you could research them the same way you research Ford or Coca-Cola.

Benjamin Graham in his book, The Intelligent Investor recommends that all investors should be wary of purchasing today’s hot new issues. Most initial public offerings underperform the stock market as a whole. And if you buy the new issue right after it begins trading, usually at a higher price, you are even more certain to lose.

Weighing the evidence objectively, the intelligent investor should conclude that IPO does not stand only for “initial public offering”. More accurately, it is also shorthand for:

  • It’s probably overpriced
  • Imaginary profits only or
  • Insiders’ private Opportunity

There is no strategy I am aware of likely to lose you more money than buying IPOs, except perhaps the horse races or the gaming tables of Las Vegas.


The Intelligent Investor – Benjamin Graham

One Up On Wall Street – Peter Lynch

4 Pillars of Investing – William Bernstein

Letters to shareholders of Berkshire Hathaway – Warren Buffett

University of Berkshire Hathaway – Daniel Pecaut, Cory Wrenn