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 businesses – and 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.

Sources:

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