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The Most Powerful Mental Model for Identifying Stocks

“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.” ~ W. Somerset Maugham – English dramatist & novelist (1874-1965)

As I’ve seen in the past 20+ years of investing in the stock market, Maugham’s thought holds a great relevance when it comes to picking up businesses for investment.

Pick up a business with good economics and with good margin of safety, and the probability of making money in the long run is high. Pick up a business with poor economics with any margin of safety, and the probability of losing your shirt, and entire wardrobe, in the long run is very high.

Understanding a business also adds significantly to your margin of safety, which is a great tool to protect yourself against losing a lot of money.

Here is what Warren Buffett wrote in his 1997 letter to shareholders…

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.

If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.

Buffett’s investment approach combines qualitative understanding of the business and its management (as taught by Philip Fisher) and a quantitative understanding of price and value (as taught by Ben Graham). He once said, “I’m 15 percent Fisher and 85 percent Benjamin Graham.”

That remark has been widely quoted, but it is important to remember that it was made in 1969. In the intervening years, Buffett has made a gradual but definite shift toward Fisher’s philosophy of buying a select few good businesses and owning those businesses for several years. If he were to make a similar statement today, the balance would come pretty close to 50:50.

Anyways, any discussion on Buffett’s focus on understanding businesses must start with how he defined various businesses as per their economics. And that’s exactly what I’ll try to do now.

Businesses are Great, or Good, or Gruesome
Buffett created three broad categories of business, which he first defined in his 2007 letter to shareholders. He wrote that either a business is great, or good, or gruesome.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%.

When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases.

It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

Buffett grouped businesses into three general categories – great, good, and gruesome – based on their return on investment profile, and explained the differences between these categories. I find what follows below as a great mental model while assessing businesses. And the characteristics that Buffett defined to distinguish between these three categories form an important part of my investment checklist.

First, the Great Business
Buffett wrote in his letter…

A truly great business must have an enduring “moat” that protects excellent returns on invested capital.

The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success.

Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Now, while most investors search for companies that have had certain competitive advantages or moats that have helped them do well in the past, or they are doing better than competitors in the present. But Buffett here is not just talking about the moat of a business, but in the endurance or sustainability of that moat.

Look at a market like India. We have had several companies doing great business at specific points in their lifetime, but have fallen from grace over years, and are now just a pale shadow of their glorious past. Whatever reasons there may be for the disappearance of moats for these companies – competition, change in industry structure, capital misallocation – the point is that all companies go through a lifecycle, from birth till stagnation or death.

To quote Horace, “Many shall be restored that now are fallen, and many shall fall that now are in honor.”

There are only handful that survive more than a few decades. You won’t find many such companies in a rapid growth market like India, where entrepreneurial spirit is high and any high-return business will attract competitors sooner than later, thereby lowering the average returns for all players over time.

Thus, the idea must be to look for companies that can survive and thrive at least over the next 20 years – businesses that have…

  • Great brands, and where consumers are willing to pay higher prices for the perceived higher value;
  • Low cost of operations, which enables them to lower prices and still maintain good margins;
  • Operate in simple and growing industries;
  • Clean balance sheets that provide them the capacity to suffer bad times; and
  • Managements with history of making rational capital allocation decisions.

Here is what Buffett writes on enduring moats…

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Now, while the management quality must be of great importance for you while picking your businesses, Buffett says the quality of the business is paramount. As he wrote…

…this criterion (of identifying businesses with “enduring” moats) eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great.

A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Now, while “growth” rules the roost when investors are searching for businesses to invest in, Buffett has a different take on this. Stability – in industry, business economics, earnings, and growth – is more important for him, than just growth.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere.

A Great Business is an Economic Franchise
Buffett terms a great business as an “economic franchise”, and believes that it arises in a business that sells a product or service that:

  1. Is needed or desired (continuous and rising demand)
  2. Is thought by its customers to have no close substitute (customer goodwill is much better than accounting goodwill, and allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price)
  3. Is not subject to price regulation (price maker)

Here is what he wrote in his 1991 letter…

The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.

Moreover, franchises can tolerate (short-term) mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.

A business that is not a franchise, writes Buffett, can be killed by poor management.

In effect, what Buffett seemingly meant was that since a bad management cannot permanently dent the prospects of an economic franchise (except due to long-term mis-management), any stock market downturn provides a great opportunity for investors to consider such businesses (that may also fall in tandem with the markets) for investment.

You must, however, be very careful confirming that a business is a franchise. After all, there’s many a slip twixt the cup and the lip.

Should You Buy and Forget Franchises?
Not really, Buffett thinks. He wrote in his 2007 letter…

There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

In other words, while it pays to pay up for quality businesses please avoid overpaying for them expecting to keep earning money from these stocks the way you or others may have earned from them in the past.

Trees, after all, don’t grow to the sky. And to repeat Horace – “…many shall fall that now are in honor.”

Buffett’s Other References to a Great Business
Here are a few other references that Buffett has made over the years in his letters, describing the characteristics of a great business…

  • Our acquisition preferences run toward businesses that generate cash, not those that consume it. (1980)
  • The best protection against inflation is a great business. Such favored business must have two characteristics: (1) An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. (1981)
  • One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. (1983)
  • Leadership alone provides no certainties: Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility. (1996)
  • The really great business is one that earns…high returns, a sustainable competitive advantage and obstacles that make it tough for new companies to enter. (2007)
  • “Moats”—a metaphor for the superiorities they possess that make life difficult for their competitors. (2007)
  • Long-term competitive advantage in a stable industry is what we seek in a business. (2007)
  • The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. (2009)

Your “Great Business” Checklist
You can use the above points to create your checklist for identifying the great businesses out there.

Alternatively, and an even better way, would be to invert the points and then avoid businesses that are not great. This, I believe would be an easier task, given the enormous number of “Roman Candles” out there – companies whose moats are illusory and will soon be crossed.

So, if you were to invert Buffett’s points on great businesses, here is how your checklist may look like.

Avoid a business that…

  • Consumes more cash than it generates.
  • Has managers who boast of certainties and invincibility.
  • Earns poor return on capital.
  • Operates in an industry where it’s easy for new companies to enter and succeed.
  • Operates in an unstable industry (maybe due to technological changes, or government regulations)
  • Requires consistent infusion of new investment to grow.
  • Doesn’t have an ability to increase prices.
  • Isn’t able to accommodate large volume increases in business with only minor additional investment of capital.

Second, the Good Business
Buffett writes that while a great business earns a “great” return on invested capital that creates a moat around itself, a good business earns a “good” return on capital.

So what is the core difference here?

Well, while a great business does not require too much of incremental capital to grow, a good business requires a significant reinvestment of earnings if it is to grow. Thus, with a high level of capital intensity, such a business requires high operating margins in order to obtain reasonable returns on capital, which means that its capacity utilization rates are all-important.

In India, leading companies from the capital goods, automobile and banking sectors will find place in this category. Buffett writes that if measured only by economic returns, such businesses are excellent but not extraordinary businesses.

Broadly, good businesses are ones that…

  • Enjoy moderate but steady competitive advantage, which typically arises due to their size and thus economies of scale
  • Require good managements at the helm, that can execute the plans well to generate high return on rising invested capital
  • Grow at a moderate to high rates, and thus
  • Require constant infusion of fresh capital

Third, the Gruesome Business
Here is where we are going to spend a lot of time, for a majority of the businesses out there would fall in this category. Buffett wrote in his 2007 letter…

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.

Most asset-heavy or commodity businesses would fall into this category. As Buffett wrote in 1983…

…as they generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

Now the question is – Why do such companies earn low rates of return? Buffett answers in his 1982 letter…

Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal.

If…costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

Now the second question is – So are all companies from such industries to be avoided at all costs?

Buffett says some of such companies do make money, but only if they are low-cost operators. As he wrote in his 1982 letter…

A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent.

In fact, when a company is selling a “commodity” product, or one with similar economic characteristics, being the low-cost producer is a must. What is more, for such companies, having a good management at helm is also very important.

From Buffett’s 1991 letter…

With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.

Such companies can also earn high returns during periods of supply shortages.

When shortages exist…even commodity businesses flourish. (1987)

But such situations usually don’t last long…

One of the ironies of capitalism is that most managers in commodity industries abhor shortage conditions—even though those are the only circumstances permitting them good returns. (1987)

When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success. (1982)

Buffett’s Brush with Gruesome Business
For the Buffett we know today – the man who has compounded money at over 20% over the last 50+ years – it may sound surprising but he had a brush with a gruesome business at the very start of his career.

The company was Berkshire Hathaway (Buffett’s present-day investment arm), and the business it was in was textile. Buffett calls it the biggest mistake of his career.

What is interesting, Buffett was fairly “happy and comfortable” owning Berkshire’s textile business till a few years after he bought it. This is what he wrote in his 1966 letter…

Berkshire is a delight to own. There is no question that the state of the textile industry is the dominant factor in determining the earning power of the business, but we are most fortunate to have Ken Chace running the business in a first-class manner, and we also have several of the best sales people in the business heading up this end of their respective divisions.

While a Berkshire is hardly going to be as profitable as a Xerox, Fairchild Camera or National Video in a hypertensed market, it is a very comfort able sort of thing to own. As my West Coast philosopher says, “It is well to have a diet consisting of oatmeal as well as cream puffs.”

Buffett had bought Berkshire simply because it was “too cheap and thus a bargain” then, and he was yet to come under the influence of “quality and moats” driven investing, which would have led him to avoid this business.

Anyways, in 1967, here is what Buffett wrote on Berkshire’s textile business…

Berkshire Hathaway is experiencing and faces real difficulties in the textile business, while I don’t presently foresee any loss in underlying values. I similarly see no prospect of a good return on the assets employed in the textile business. Therefore, this segment of our portfolio will be a substantial drag on our relative performance if the Dow continues to advance. Such relative performance with controlled companies is expected in a strongly advancing market, but is accentuated when the business is making no progress.

As a friend of mine says. “Experience is what you find when you’re looking for something else.”

Then, in 1969, on being asked why he continued to operate the textile business despite not getting a good return on it, Buffett wrote…

I don’t want to liquidate a business employing 1100 people when the Management has worked hard to improve their relative industry position, with reasonable results, and as long as the business does not require substantial additional capital investment. I have no desire to trade severe human dislocations for a few percentage points additional return per annum. Obviously, if we faced material compulsory additional investment or sustained operating losses, the decision might have to be different, but I don’t anticipate such alternatives.

Good Managers Vs. Gruesome Businesses
Buffett has mentioned several times in the past that even a great management would find it difficult to bring order back to a business with poor economics, like the textile business, or commodity or airline businesses.

So, while Buffett had a great manager in the form on Ken Chase at Berkshire’s textile business, the business still floundered and was sold off in 1985.

Here are things Buffett has written over the years on why even good managers cannot turn around bad businesses…

  • In some businesses, not even brilliant management helps I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. (1989)
  • Good jockeys will do well on good horses, but not on broken-down nags. (1989)
  • When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.”) (2006)
  • My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). (1985)
  • Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. (1985)

As per Buffett’s estimates, had he never invested a dollar in the textile business and had instead used his funds to buy a business with a better economics, his returns over the course of his career would have been doubled.

Like for Buffett, a gruesome business is not just a terrible investment for you, but also a major distraction that would cost you in terms of opportunity cost.

Lessons Learned
What lessons can we learn from Buffett’s textile endeavours? Well, there are two, in Buffett’s words.

One, “If you get into a lousy business, get out of it.”

Two, “If you want to be known as a good manager, buy a good business.”

Also, if you own the best business in a bad industry (like textiles, airline, commodities, and retailing), please note what Buffett wrote in 1985…

“A horse that can count to ten is a remarkable horse – not a remarkable mathematician. Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business.

Buying a Gruesome Business Cheap
Well, that’s exactly what Buffett did in case of Berkshire Hathaway. Under the influence of Benjamin Graham, and without considering the industry’s economics, Buffett bought just because the stock was trading extremely cheap.

Then, after offloading the textile business, Buffett wrote this in 1989…

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.

Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.

Time is the friend of the wonderful business, the enemy of the mediocre.

This is an extremely important lesson for you if you thought buying a stock cheap would save you from the ills of a poor underlying business.

Summing Up
I have tabulated the distinction between the great, good, and gruesome businesses as under…

To sum up Buffett’s description of great, good, and gruesome businesses, here is what he wrote…

…think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

If you have to remember just one lesson from today’s post, it must be – Time is the friend of the wonderful business, the enemy of the mediocre. So please pick and choose very carefully.

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