Today we look at the types of businesses that investors should invest in. These ideas are from Warren Buffett’s letter to shareholders written in 2007. John Huber summarized these ideas in his post on basehitinvesting.com.
Category #1—High ROIC Businesses with Low Capital Requirements
Long-term competitive advantage in a stable industry is what investors should seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. Investors can simply take the lush earnings of the business and use them to buy similar businesses elsewhere. 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.
Category #2—Businesses that Require Capital to Grow; Produce Adequate Returns on that Capital
There aren’t many companies in the first category. Typically, companies that increase their earnings from Rs5 million to Rs100 million require, say, Rs400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments. A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. If measured only by economic returns, this business is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most companies. For example, large investment in regulated utilities falls squarely in this category. Investors will earn considerably more money in this business ten years from now, but they will invest large additional capital to make it.
Category #3—Businesses that Require Capital but Generates Low Returns
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.
So we might think two categories of great businesses:
· Those that can retain and reinvest most/all of its earnings at high rates of returns
· Those that don’t have any reinvestment ability within the business but can still grow earning power with little to no incremental capital
In a durable business with predictable cash flows, the latter category leads to a compounding effect that sees earning power per share impacted by the absolute growth of earnings as well as the steadily shrinking share count. Both types of businesses are rare birds, but the second category (businesses that can produce sizable free cash flow using very little capital and can grow its earnings through pricing power) is exceedingly rare, but probably the most valuable.
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