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How to think about businesses the Warren Buffett way

Here is some timeless advice from Warren Buffett on how to pick good businesses to invest in

How to think about businesses the Warren Buffett way

The easy pile and the difficult pile
The very first decision in investment analysis that you will need to make is whether you can understand a business or not. There will be a great number of businesses that you can understand and a great many you may not. If you don't, that is not a reason to fret. No single person can have insights about all the industries out there. The important thing to do is to segregate businesses into these two piles: the ones you understand and the ones you don't. When you've done that, take up the easy pile and look for simple businesses.

What is a simple business? A simple business is one where it is relatively easy to evaluate where the company is going to be in 10 or more years. ITC is very likely to remain a dominantly cigarette business. Indian Hotels will remain a hotel chain. GSK Consumer will continue to sell Horlicks 10 years from now. Businesses where you can say with some degree of certainty what they are likely to be doing a decade from now are the ones you should focus on. Such businesses make it easy to understand the dynamics of the company, what the demographics will be like and how the company will be placed in the industry.

Let's take the example of GSK's Horlicks. Generation after generation of small children are fed Horlicks more than twice a day. With rising income and a dominant market share, you can be pretty sure that the company will still be around 10 years from now selling the very same product. This is a classic example of a simple business.

Read up
Once you've got hold of businesses that you understand, the next step involves reading, a lot of reading. Read the annual report; read industry analysis; read about the competitors and the changes in the industry. Also, get your hands on the analyst conference call transcripts, now increasingly available on company websites - both of your target company and its competitors. These transcripts contain a lot of first-hand information directly from the management about the state of the company and the industry - information that is never ascertainable from quarterly result filings or news reports.

What to look for in a simple business?
Look for businesses with high return on capital for a long period of time. The decorative-paints market leader Asian Paints has reported an average return on capital of around 32 per cent in the last 10 years. Very few companies can report such high levels of returns on a consistent basis. Also, where companies do earn high returns on capital, look for managements that operate in the interest of shareholders. You will find a number of companies that do well but where the management often keeps or takes away most of the gains for itself.

Look for businesses that don't need a lot of capital
Look for businesses that don't need a lot of capital investment to run operations. Castrol India is one such business that operates without requiring a lot of capital reinvestment and has returned the excess money to shareholders generously over the past decade.

Amongst the worst businesses are those that require regular infusions of capital to run day-to-day operations. A number of online shopping stores survive only on fresh investments made by strategic investors in regular fund-raising exercises. Cab-aggregator services fall in this category, too. If any of these come out with an offer for sale, give such businesses a pass if they remain on life support from large strategic investors.

Look for companies that own share of mind
If you want to get your house painted, there is a very high chance that the first name that comes to your mind will be Asian Paints. If you want a strong adhesive, you will think of Pidilite's Fevicol. If you want to buy a lasting television set, you are more likely to think of Sony. If you are looking for wires or switch boxes or miniature circuit breakers (MCBs), you are more likely to think of Havells. For coffee, it's Nestle's Nescafe. In malt food, it's Horlicks. In baby food, it's again Nestle's Nan.

The above-mentioned companies all have moats around them. They also have one thing no competitor can easily replicate - share of mind. Through extensive use of effective advertising, targeting and communication that in some cases have run over many decades, these companies have created a share in the consumer's mind that is very difficult for the competitors to take away. Of course, some names fade away with time or become obsolete, but generally, the greater the share of mind a company has, the greater it is likely to remain a lambi race ka ghoda. You want such companies in your portfolio.

Think of investing as buying a company
A great number of new investors just buy any stock that's the flavour of the season or whatever their broker or friend or uncle advises, waiting to make a quick buck. A great many fortunes have been destroyed this way.

It is a rare phenomenon to come across investors whose holding period extends to five years today. Those with a 10-year holding period are a species near-extinct in the 'buy-today-sell-tomorrow' age. Interestingly, while younger investors are quick with mouse clicks to sell at an instant's notice, older investors have hung onto their investments for decades, producing investment results that no young investor, even with an explosion of knowledge, can easily match.

Buffett captures this behaviour perfectly below:
"So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten years from now. If I can't see where they will be ten years from now, I don't want to buy it. Basically, I don't want to buy any stock where if they close the NYSE tomorrow for five years, I won't be happy owning it.

I buy a farm and I don't get a quote on it for five years and I am happy if the farm does OK. I buy an apartment house and don't get a quote on it for five years; I am happy if the apartment house produces the returns that I expect. People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy."

Look for companies with low or negative working capital
A back-of-the-envelope rule: companies that get upfront cash from customers and pay suppliers later will generally be able to wring out higher returns on capital than others. Take airlines for example. They take money from flyers at the time of booking that may be at times months away from the actual travel date and use that money for operations. A number of FMCG companies similarly sell in cash and pay suppliers much later. Any subscription-based business falls under this category. These companies generally do not have cash-flow problems and if they do not do anything foolish, they remain debt-free and profitable for a long time.

Management matters
The best business with a great opportunity means little if the management heading it is incompetent or, worse, dishonest. Satyam Computers was operating in an industry that held a lot of opportunity. That meant little for investors who found out one morning in January 2009 that Ramalinga Raju, its chairman, was cooking the books. This, just four months after Satyam was pronounced the '2008 Winner of the Golden Peacock Award for Corporate Governance under Risk Management and Compliance Issues'. Many investors saw their life's savings vanish post the scam.

In more recent times, Shahid Balwa of DB Group stands accused in the 2G scam. A number of real-estate companies have usurped home buyers' advances, without building houses for them. In these days of information overload, it is increasingly common to uncover news about promoters of companies - where they party, what they are up to, what they are doing with their time. It is also becoming increasingly easier to find out promoters that are honest. Ashiana Housing's founder returned home buyers money when a plan fell through. Promoters of Lakshmi Machine Works, for instance, are known for their conservative nature. The management of Divi's Labs is considered hard working and trustworthy by big pharma clients.

Estimate value
The next step is to evaluate the value of a business. Many investors, especially amateurs, get lost in this step. Most do not ascribe any value to a company and just go with the price of the stock. The value of the company and the stock price are two completely different things. The following example from Berkshire's 2007 annual meeting illustrates the thought process that you need to adopt:
"Let's say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7 per cent return, so you'd pay $1,000/acre. If it's for sale at $800, you buy, but if it's at $1,200, you don't.

Do this exercise with a couple of companies that you have been analysing. How much would you pay if you want to achieve a particular return on your investment? Use earnings yield for this exercise. This is the inverse of the P/E ratio and tells you what your investment would earn at the current stock prices.

In heated markets, a number of quality names will trade at very low yields. In downtimes, these same companies become attractively priced. Take a look at your favourite companies and see their earnings yields. Are they attractive compared to, say, the government bond? If the initial return is low, are the earnings likely to grow fast enough to beat the return you would have got with a bond? If not, why are you interested in it? Is the dividend yield attractive with a low payback period?

Spend some time thinking about businesses this way and you'll vastly improve your stock-selection process and investment returns in the long run.

This story was first published in December 2017.