Despite what most CEOs may tell the public about their own company, a good business is rare. Only a handful of companies will pass a value investor’s checklist before being considered for investment. Over his investing career, Warren Buffett has given us the top criteria he looks for before considering a purchase of a company’s stock.
A good business has a wide moat, a higher rate of innovation than its competitors, the ability to increase earnings with each dollar it invests, good management, and a powerful brand. They can maintain their competitive advantage and increase profits over a long period.
A wide moat
According to Warren Buffett, his main goal when finding a good company is to find one with a broad and long-lasting moat. A moat is the business’s ability to maintain its competitive advantage, continue its profitability, and to be able to hold off the competition into the future. And its competitive advantages are the factors that allow a company to offer certain products and services that are better than its competitor’s equivalent while being profitable. When looking at a company’s moat, it is essential for value investors to ask, why does this moat exist? How long will it last? And, how much does it depend on the skill of its managers?
A moat can come in many forms:
- Low-cost provider– Companies can produce products or services of the same or similar quality to their competitors at a lower cost to the customer. They can also offer superior products to their competitors but at the same price and often are more profitable due to lower operating expenses. For example, Geico can offer lower-cost insurance by going direct to consumers without local agents.
- Switching costs– Companies can make it harder for customers to switch to a competitor by incurring costs. It can be monetary, psychological, time, or effort-based. For example, if you have an Apple computer and use software unique to that brand, switching to a Microsoft computer is costly in terms of money, time, and effort.
- Economies of scale– The larger a company becomes, the cheaper it can produce its products and services due to economies of scale—both from increased production efficiencies and lower input costs. New companies entering the same market will struggle to compete in pricing due to their size.
- Network effect– A term made famous by social media companies such as Facebook, the network effect increases the value of a company’s products or services as the user base grows. For example, the more users on a platform, the more exposure a company can get through advertising. This advertising can then attract more users if the products and services provide value.
- A strong brand– Branding is one of the strongest psychological forces that affect consumers. Consumers get tied into a company based on their own experiences with its products and services, influenced by advertising or peers. Branding drives loyalty which in turn drives sales and profitability. The brand’s strength allows the company to charge a premium pricing while still retaining its customer base, something a company without a strong brand cannot do.
Rate of innovation
Apart from a wide moat, the company’s rate of innovation is the most critical factor in maintaining its long-term competitive advantage. What matters in business is the pace of innovation. That is how companies become or remain competitive. As technology and consumer behavior change, so must companies, or as the saying goes, evolve or die. We can see this from history when once-high-flying companies are no longer around, and more innovative companies have taken their place.
When innovating, a company has to develop new products and services constantly, but they have to be quicker than its competitors. They need access to the right resources to make their ideas a reality, such as access to human capital, and the company needs access to the raw materials to create the product or services. If a company continually releases worse products or provides sub-par services, its competitive edge decreases, and the chance of a competitor overtaking them increases.
Incremental return on capital
A great company generates mountains of cash and can invest that cash to produce higher and higher earnings rates. One of the issues of really successful companies is that they often run out of places to invest their free cash flow that will return a profit at the same rate or higher than what they are currently earning. A great example of an excellent capital allocator is Amazon. When Amazon dominated the online book sales market, they moved to CDs and DVDs, then everything else; many thought they could not grow anymore. Then they launched AWS, Amazon’s cloud service, which was even more profitable than their eCommerce business. They continue to innovate with streaming and subscription services, advertising, and increasing operating efficiencies.
A business an idiot could run
The best companies are essentially monopolies, such as the only newspaper in town; it matters far less how well the business is run because the company already has a 100% market share. A monopoly can be run by incapable management and still be highly profitable.
Great management
Contrary to the comment above, some companies need excellent management, mainly when there is much competition in their industry. When studying how well a manager can run a business, you can learn a lot about what decisions they have made in the past and how well they have turned out. You can also look at how well they have allocated capital over time. Effective allocation of capital is one of the most effective ways a manager can keep the company’s competitive advantage. You can compare their performance against their competitors to gauge how well they have operated in the environment of their particular industry. Good managers also treat their shareholders as owners who only think about benefiting themselves and often do not consider what’s best for the shareholders.
Buying at the right price
A great company should remain great for decades, not just a few years. You want to find companies that you would be happy putting into your portfolio and then for the stock market to close for 20 or 30 years. However, your returns are helped tremendously by the price you pay; if you buy when it is cheap, there is more upside; your returns will be reduced if bought when expensive. It is still better to pay a higher price for a great company than to pay a great price for a mediocre company. Once you find a handful of great companies, it is easier to keep track of their value and buy shares when their prices are more attractive.
