Every stock has a business behind it. Ignoring the underlying business and paying attention only to the stock price is a recipe for trouble
Many investors will never pause for a moment to think about the business of the company they are willing to bet their money on. Many will just put their money where their brokers, friends and associates will tip them to. But no investment - however attractive the entry point - can outperform the underlying business, especially in the long term. This is one truth that escapes most investors.
Busting the myth
Many investors do not realise that more than being a successful stock picker, Buffett is a successful business buyer. His success has more to do with the wonderful businesses that he owns rather than their stock price movements.
Here's what Charlie Munger has to say about how important it is to pick high-quality businesses. "We've really made the money out of high-quality businesses... Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 per cent on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6 per cent return - even if you originally buy it at a huge discount. Conversely, if a business earns 18 per cent on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result. ('A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management & Business', Charlie Munger).
Ideal type of business
Broadly, in the world of Buffett, businesses are categorised into two classes: those that require little capital re-investment and those that continuously require fresh capital to survive. Says Munger, "There are two kinds of businesses: The first earns 12 per cent, and you can take it out at the end of the year. The second earns 12 per cent, but all the excess cash must be reinvested - there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit'. We hate that kind of business." (Berkshire Annual Meeting, 2003).
Businesses that do not require too much capital top Buffett's list. "Great consumer businesses need relatively little capital. Where people pay you in advance (magazines, insurance), you are using your customers' capital. But the rest of the world knows this and they get expensive. It can be competitive to buy them. Business Wire - it doesn't require capital. Many service businesses require little capital. When successful, they can be something."
"You could run Coca-Cola with no capital. There are a number of businesses that operate on negative capital. Great magazines operate with negative capital. Subscriptions are paid upfront; they have limited fixed investments. There are certain businesses like this. Blue Chip Stamps - it got float ahead of time. There are a lot of great businesses." (Berkshire Annual Meeting, 2010).
Searching for moats
Buffett has single-handedly promulgated and popularised investing in companies that have a strong moat. In a lecture at the University of Florida Business School in 1998, Buffett talks about searching for moats.
"Our managers of the businesses we run, I have one message to them, and we want to widen the moat. We want to throw crocs, sharks and gators, I guess, into the moat to keep away competitors. That comes about through service, through quality of product, it comes about through cost, sometimes through patents, and/or real estate location. So that is the business I am looking for."
"Now what kind of businesses am I going to find like that? Well, I am going to find them in simple products because I am not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Gates is the best businessman I have ever run into and they have a hell of a position, but I really don't know what that business is going to look like ten years from now. I certainly don't know what his competitors will look like ten years from now."
"I know what the chewing gum business will look like ten years from now. The internet is not going to change how we chew gum and nothing much else is going to change how we chew gum. There will be lots of new products. Is Spearmint or Juicy Fruit going to evaporate? It isn't going to happen. You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley's. I can't do it."
"That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can't do it. Those are good businesses. Now give me some money and tell me to hurt somebody in some other fields, and I can figure out how to do it." (Lecture at the University of Florida Business School, 1998).
Concept of pricing power
Buffett emphasises investing in companies with pricing power. Pricing power is the closest indicator of how strong a business franchise is.
Buffett says, "The first question is 'how long does the management have to think before they decide to raise prices?' You're looking at a marvellous business when you look into the mirror and say 'mirror, mirror on the wall, how much should I charge for Coke this fall?' [And the mirror replies, 'More'.] That's a great business. When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, [and say] 'Just another half cent a yard'. Then you get up and they say, 'We won't pay it'. It's just night and day. I mean, if you walk into a drugstore, and you say, 'I'd like a Hershey bar', and the man says, 'I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar'. You just go across the street and buy a Hershey bar. That is a good business. The ability to raise prices - the ability to differentiate yourself in a real way, and a real way means you can charge a different price - that makes a great business." (Lecture at Notre Dame, 2005).
Return on incremental capital
Many businesses require little capital to run, but fewer still can generate high returns on invested capital. Why is this important? Buffett explains, "The ideal business is one that generates very high returns on capital and can invest that capital back into the business at equally high rates. Imagine a $100 million business that earns 20 per cent in one year, reinvests the $20 million profit and in the next year earns 20 per cent of $120 million and so forth. But there are very, very few businesses like this. Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money, but can't generate high returns on incremental capital - for example, See's and Buffalo News. We look for them [areas to wisely reinvest capital], but they don't exist." (Berkshire Annual Meeting, 2003).
This story was first published in June 2015.