Business Characteristics - the Great, the Good and the Gruesome

THE GREAT BUSINESS = HIGH RETURNS + POWER TO RAISE PRICES + ENDURING COMPETITIVE ADVANTAGE

·      The great business demonstrates high return on invested capital and can it grow its earnings with only minor additional investment of capital. In 1985 they [Nebraska Furniture Mart, See’s Candy and Buffalo Evening News] earned an aggregate of $72 million pre-tax. Fifteen years ago, before we had acquired any of them, their aggregate earnings were about $8 million pre-tax. While an increase in earnings from $8 million to $72 million sounds terrific - and usually is - you should not automatically assume that to be the case. You must first make sure that earnings were not severely depressed in the base year. If they were instead substantial in relation to capital employed, an even more important point must be examined: how much additional capital was required to produce the additional earnings? In both respects, our group of three scores well. First, earnings 15 years ago were excellent compared to capital then employed in the businesses. Second, although annual earnings are now $64 million greater, the businesses require only about $40 million more in invested capital to operate than was the case then. The average American business has required about $5 of additional capital to generate an additional $1 of annual pre-tax earnings. That business, therefore, would have required over $300 million in additional capital from its owners in order to achieve an earnings performance equal to our group of three. (1985).

·       A great business has the power to raise prices without losing business to a competitor.  An economic franchise arises from a product or service that:  (1) Is needed or desired; (2) Is thought by its customers to have no close substitute and; (3) Is not subject to price regulation. 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 mis-management. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage. (1991).

·       Moat can widen or shrink; a great business has long term competitive advantage in a stable industry. 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 (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed. (2007).

·       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)

·       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)

THE GOOD BUSINESS = GOOD RETURNS ON INVESTED CAPITAL

·       Good returns on invested capital may require large incremental investment of capital. One example of good, but far from sensational, business economics is our own Flight Safety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure. Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million. (2007).

·       High capital business requires high operating margins to achieve decent returns. At FlightSafety…as much as $3.50 of capital investment is required to produce $1 of annual revenue. With this level of capital intensity, FlightSafety requires very high operating margins in order to obtain reasonable returns on capital, which means that utilization rates are all-important. (2004)

THE GRUESOME = CONSUMES HUGE CAPITAL + LOW RETURN

·       Asset-heavy businesses 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. (1983)

·       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. (1982)

Warren buffett’s three “G” business framework: To sum up, 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. (2007). There are only a handful of Great business; most businesses are Good or Gruesome.