Every year Warren Buffett writes a letter to its shareholders informing them about the year gone by and his outlook on the future as well as the good and bad things done in the past by his company.
This letter is a great source of knowledge and wisdom as it comes from the world’s best investing mind and has a frank tone to it.
The letter for 2007 had his pearls of wisdom about how to pick the right company for investment. While Buffett goes ahead and buys the whole company common investors can take this wisdom and apply them to their own investment decisions.
The letter under a sub-heading “Businesses – The Great, The Good and the Gruesome†takes a look at the factors which make a business attractive. In this article we discuss the great businesses as discussed by Buffett in this letter.
The following four factors are discussed in the letter:
a) Business that is easy to understand
b) Favorable long term economics
c) Able and trustworthy management
d) Sensible price tag
Buffett discusses the need for a truly great business to have an enduring ‘moat’ . This was a term coined by Buffet himself who uses this to describe a competitive edge of one business over its competitors such as being a low cost producer in the case of Costco or being a global brand in the case of Coca – Cola. The need for such a moat is that any successful business would attract competitors and in the wake of competition a business should be able to protect its market share.
In addition to having a ‘moat’ Buffett insists that the moat should be an enduring one. By saying that there are a lot of companies that get eliminated. These are companies that operate in industries prone to rapid and continuous change. The obvious reason for this is what could be a competitive edge today may eliminate altogether tomorrow because of the changing economics of the industry.
Another interesting thing that comes along with this definition is that Buffett says that a truly great business should never really have to depend on a great CEO. A great business can’t be one whose success depends on superstars. Of course having a great CEO is an added asset but it shouldn’t be a factor upon which the success of the business is totally dependent.
Having established that a business has got a long term competitive advantage Buffett develops the concept further and states that long term competitive advantage in a stable industry is what makes a stock interesting. A great company in such an industry is one that comes with rapid organic growth however even if the business doesn’t have rapid growth the earnings from this business can be taken and invested in another business which has rapid growth. The example that Buffett takes is See’s Candy which was bought by them for 25 million dollars in 1972 and which had a pretax profit of 5 million dollars. The business needed a capital of 8 million dollars to run and this meant that it was earning a cool 60% profits on invested capital. In the last year this company made a profits of 82 million dollars with a capital investment of just 40 million dollars. So effectively the capital that had to be invested in the company was $32 million and the profits so far have totaled to $1.65 billion which have been re-invested in into other attractive businesses.