The Perfect Business
March 1, 2011 3 Comments
The best and easiest way to make money either as a businessperson or an investor is to get hold of an as near to perfect business as possible.The best businesses have the following features:
- High profitability. If the business provides customers a product or service they need or want very much, and only this business can provide it, and there are few substitutes available then this firm can charge a premium price far above the costs it incurs.
- High returns on capital. A business with high margins ceases to be very attractive if it is very capital intensive and requires massive amounts of capital to launch and/or remain in business. The greatest businesses require little or no money to start, can grow without major additions of capital, and do not require much maintenance cap ex.
- An enormous moat. To ensure high margins and return on capital in the future it’s critical for a business to have major competitive advantages that are unlikely to dissipate over time. The key here is lack of change .Rapid change as in the hi- tech sector,benefits consumers but is very bad for investors. To quote Warren Buffett, “We see change as the enemy of investments… so we look for absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs…. I guarantee that Coke, Wrigley’s , and Gillette will dominate. The Internet won’t change what brands people like.”
- Profitable reinvestment opportunities. The greatest businesses can reinvest their robust free cash flows back into the business at equally high rates of return on capital. Consider this: Warren Buffett has often lamented the fact that See’s Candies has never been able to expand much beyond its historical West Coast markets. It’s a fabulous company and was one of his best acquisitions ever, but the inability to reinvest its free cash flows back into growing its operations makes it an inferior business to, say, Wrigley, which has been able to grow globally over the years.
- Future growth. Growth is good but only while profitability is retained.Growth benefits owners and shareholders only if a business can continue to earn good returns on incremental invested capital.
- Good cash flow dynamics. Some businesses require huge amounts of working capital, while the best companies actually receive cash from customers before they have to pay their vendors. This is measured by the cash conversion cycle , which is simply days of inventory plus days of accounts receivable, minus days of accounts payable.This factor is a major differentiating factor in a commodity businesses,especially those in which inventory is losing value by the day.