The Characteristics of a Wonderful Business

The notion that investment results follow business performance (in due time) is one of investing’s greatest maxims. One of the investors that has made a carreer running a very concentrated portfolio of outstanding companies is Chuck Akre. In his visit to Google, Akre brought up the topic on how to identify them, among many of the lessons that he has learned over the years.

Akre opens up the conversation discussing how he went from an English major without any finance knowledge to learning about investing. He touches upon reading John Train’s Money Masters of our Time, where one of the first at-lentgh Buffett interviews surfaces. There, Buffett outlines the characteristics of an outstanding business, the type that one can own over the long-term. While there are many ways to invest, and Buffett has certainly deviated from the long-term compounder approach over his carreer, we believe the approach is very interesting, tax-efficient, and rewarding.

The 11 characteristics of wonderful businesses according to Buffett

We classified the 11 characteristics based on where to look for them. We include additional thoughts for each classification.

Reading financial statements (income statement, balanche sheet, cash flows):

• They have a good return on capital without accounting gimmicks or lots of leverage
• They see their profits in cash
• Their earnings are predictable
• They have low inventories and high turnover (i.e. they require little continuing capital)
• There is a high return on the total of inventories plus plant.

Prices and multiples only tell a fraction of the story: regardless of whether you’re looking at a public or private firm, digging into a company’s financial information is crucial to make an informed investment decision (or recommendation).

While we are completely aware the “accounting” stuff is perhaps the least glamorous (okay, probably the most arid) part of the investment process, it can be very helpful to have some working knowledge of basic accounting principles and concepts. To understand why, simply bear in mind two things: 1) a company’s management still has an important degree of discretion when preparing their financial statements (whether public or private), and 2) public firms are constantly under pressure to achieve short term results, which goes against this idea of long-term compounding.

Comparing sector competitors and regulatory landscape

• They are understandable
• They have strong franchises and thus freedom to raise prices
• They don’t take a genius to run
• They are not natural targets of regulation
• Overall: the best business is a royalty on the growth of others, requiring little capital itself

Financial information must reflect the company’s strengths and competitive advantages. It is important to understand a company not in isolation, but in relationship to the environment on which it operates. What could be seen as a unique advantage may change in the future, as new companies are able to more efficiently replicate a particular technology for example, or as regulations limit a company’s pricing power.

Reading MD&A statements and annual report letters

• The management is owner-oriented (this needs to be reflected in the financial statements too)

Let’s keep it simple: Skin in the game.

Naturally, the 11 factors interact among themselves and are not isolated. For example, high ROIC is only sustainable if there is unregulated pricing power, focused management and good execution, all while warding off competitors (as naturally, a business earning high ROIC should have a target on their back). The implementation of this list seems pretty straightforward, however, it is a bit tricky, given that each business entity and the industry in which they operate are different.

To solve the issue of complexity, our experience suggests two solutions. The first one is insatiable curiosity, as knowledge generally compounds, patterns emerge and comparisons become clearer. With time, we get a very good sense of base rates (or the % of a population that exhibits a certain characteristic), allowing us to better understand what could happen in the future. For this, we recommend following Charlie Munger’s principles of forming an array of mental models, or proven methods / ideas that explain most of the dynamics in the world around us. A great place to start is listening to Charlie Munger himself (we recommend this 1995 speech: The Psychology of Human Misjudgment).

As we gather knowledge, we might fall victim of a false sense of expertise, or overconfidence. To overcome this (besides facing the humbling Mr. Market himself), we suggest incorporating the idea of the circle of competence, a concept we have written at length here. Here also is a video of Buffett answering the question on how to develop a circle of competence himself.

All of this sounds wonderful, yet, we dare to add one component which we believe is vital: reasonable valuation. Even the best business in the world is not worth an infinite amount of dollars. Our experience suggests that this is perhaps the hardest part of investing in a compounder. Most of these companies are widely followed and priced close to perfection nearly all the time. Therefore, patience is key in two ways: 1) To wait for the right entry point (generally investing at the average valuation range suffices) ; and 2) the patience to hold them for prolonged periods of time to allow the magic of compound interest multiply capital (in spite of natural gyrations of the stock market).

To spark debate and provide you with some of the companies we believe they can call themselves “wonderful”, we list the companies (tickers) below. We would love to hear what you think, or add some companies that you would classify as wonderful.

• FB
• MSFT
• CHKP
• EPAM
• VRSK
• COST
• MCO
• MA
• V
• MSCI
• AMZN
• ANSS
• BR
• SBAC
• AMT
• VRSN