Investment is most intelligent and likely to be more successful when it is most businesslike
"More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain hunting, with results ranging from tolerable to terrible. Fortunately, my mistakes have usually occurred when I made smaller purchases. Our large acquisitions have generally worked out well and, in a few cases, more than well." - Warren Buffett wrote in Berkshire Hathaway's Annual Letter, 2012.
One of the most important factors while picking stocks is to look at the quality of the business. It's not enough for a stock to be backed by a big name investor or be an upcoming IPO. When investing your hard earned money, it pays to remember the wise words of Buffett's mentor, Benjamin Graham -- "Investment is most intelligent when it is most businesslike. I should add that it is most successful when it is most businesslike."
Buffett's transition to quality investments
Buffett himself transitioned from Graham's quantitative-based investing to giving precedence to quality. Here's Charlie Munger, Buffett's partner at Berkshire, commenting on their See's candy investment.
"If See's had asked $100,000 more, Warren and I would have walked - that's how dumb we were. [Munger's friend] Ira Marshall said you guys are crazy - there are some things you should pay up for, like quality businesses and people. You are underestimating quality. We listened to the criticism and changed our mind."
Low quality businesses
Think about it. Would you invest your hard earned money in a venture that, say, earns 2 per cent per annum? You wouldn't. But many investors forget to pay attention to the quality of the business that they are putting their money into.
What happens when you invest in a low quality business? If the management is able to turn things around and returns improve, it's another story, but when managements cannot improve already low returns that a business earns and in fact returns fall even further, external financing generally goes up and shareholder returns come down.
The table below lists out companies that started off with low returns on capital employed (ROCE) five years ago but couldn't improve the quality of the business. Make a note of the debt and stock price returns.
When companies start improving their returns, the opposite happens. External debt often reduces and stock prices move up in a significant manner. See the table 'Increasing returns on capital'. It lists out companies that reported poor ROCE five years back but have improved those numbers since. Look at the stock prices that have followed the ROCE.
High quality businesses
No stock price performance can escape the quality of the underlying business. Whenever picking stocks, keep an eye out for the quality of the business if you want sustained long term outperformance of your investment. Here's Munger explaining again what investing in high quality business does to your portfolio returns.
"We've really made money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyse what happened, the big money's been made in the high quality businesses. And most of the other people who have made a lot of money have done so in 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 are 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 a fine result. So the trick is getting into better businesses."
See the table 'High-quality businesses'. It lists out some of the highest quality large businesses you can find today. Keep in mind a high ROCE is just the starting point. There are a number of other factors that you should consider before you make up your mind to invest in any of them.