One of the greatest investors of all time, Warren Buffett, is renowned for sharing his financial knowledge with shareholders through his annual letters of Berkshire Hathaway. Despite decades of market variations, these observations have been true. Buffett explains which companies he prefers and which he avoids in one of his annual letters.
Buffett starts by describing the standards by which he and his long-time business partner, Charlie Munger, chose investments. They begin by seeking for businesses that have:
- An easy-to-understand business;
- favourable long-term economics;
- capable and reliable management; and
- a fair price tag.
However, this is only the beginning point. In addition to these points, he divides businesses into three major groups – A Great Company, a Good Company, and a Horrible Company.
Let us see all the 3 categories of businesses one by one.
A ‘Great’ Company:
A great company, in Buffett’s opinion, is one that has a competitive edge, or “moat.” An enduring ‘moat’ that safeguards superior returns on money spent is essential for a genuinely outstanding firm. The nature of capitalism ensures that rivals will constantly attack any company’s ‘castle’ that is making a lot of money. Therefore, a strong barrier—such as a company’s low-cost production or strong global brand—is necessary for long-term success.
Buffett further emphasizes how they exclude businesses in sectors that are subject to frequent and fast change because of this “enduring” characteristic.
What we need to see in a firm is a sustained competitive position in a stable sector. It is referred to as a “Great Company” if it has rapid organic development. However, such a firm is lucrative even in the absence of organic growth.
Buffett also cautions against businesses that just have good management. A company cannot be considered great if it needs a superstar to achieve outstanding outcomes.
Buffett used Berkshire Hathaway’s oldest investment, See’s Candies, as an illustration of a “Great company.” The company’s industry, which is boxed chocolates, is uninteresting since US per capita consumption is very low and stagnant. The firm grew by 2% annually, yet it needed little reinvestment because of its great return on capital. Therefore, the remaining earnings were utilized to purchase other attractive businesses. As a result, See’s Candies has created several new revenue sources for Berkshire Hathaway.
A ‘Good’ Company:
All things considered, finding businesses such as See’s Candies is not simple. Buffett admits that even if they frequently need additional capital investment, good enterprises may nevertheless turn a profit. Buffett notes that while this isn’t always a negative thing, economic conditions are far less favourable here than in ‘great’ companies. A business that requires significant capital increases to fuel its expansion could end up being a profitable investment. Buffett, however, believes that having a steady flow of income with almost no significant capital needs is always preferable.
When evaluated only by financial gains, a good firm is one that is superb yet not exceptional. It could have a big edge over competitors, but in order to increase profits, it also has to reinvest more. It has the same put-up-to-earn-more proposition as the majority of businesses in this category have. In five to ten years, we can generate a lot more money in these kinds of businesses, but it will need billions of dollars as investment to succeed for a long period of time.
A ‘Horrible’ business:
Although one’s portfolio can accommodate ‘good’ businesses, horrific or gruesome ones shouldn’t be included. These are companies that consume enormous sums of money. Buffett explains them as follows: “The most disastrous sort of business is one that expands rapidly, consumes substantial investment to support the growth, but earns little or no money.”
Without hesitation, he cites the aviation sector as an example of a terrible sector. Since their first flight, the airline industry has had an unquenchable need for finance. Drawn in by growth when they ought to have been discouraged by it, investors have been pouring money into an endless hole (This is not a “No-No” for airline industry, but we have to choose our investments in these kinds of sector furthermore cautiously is what Buffett meant to say in his annual letters).
Final words:
Consider these three company categories to be three different kinds of “savings accounts.” The interest rate paid by the ‘great’ one is quite high and will continue to increase over time. The ‘good’ one offers a competitive interest rate that may be earned on additional deposit of money. Finally, there is the ‘horrible’ account, which requires you to keep depositing money while providing you with poor or inadequate returns.
Buffett provides a straightforward but important lesson: while assessing a company’s return on capital and the necessary reinvestment, an investor has to pay close attention to two important aspects. That is, there should be little need for reinvestment and a good return on capital. High reinvestment and a high return on capital might still be acceptable, but both being low is a sure-fire way to fail.
