Nov 25, 2009|
The best business to invest in
There is one question investors often ask. What is the single most important criterion one should look for in an investment? When it comes to stocks there are two important things to consider – the price at which the stock is available and the underlying business. Let us keep the price factor aside and focus on the underlying business.
The underlying business
A study of the underlying business involves two aspects. A qualitative study involves understanding the sustainable competitive advantage of the business. A quantitative study looks at the financial health and performance of the business. Let us focus on the quantitative aspects. At the most basic level, the investor should look for two things – how much capital does the business employ and the rate of return that the business generates on the capital.
Employ capital or generate returns
"The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find." – Warren Buffett's letter to shareholders, 1992
Many investors know that one should look for businesses that generate high rates of return. But the matter is not quite as simple. It also depends on the type of investor.
Let us consider two types of investors – the small investor and the large investor. The small investor has a small investible corpus. Imagine Warren Buffett at the beginning of his career. The large investor has a large investible corpus. It is the situation Warren Buffett is in today. The main difference between the two is how much capital one would like to be returned back. With a small investible corpus, the investor can chase the highest return from a variety of opportunities. Hence, he would want the company that he invests in to return any excess cash that it generates so that he could invest it elsewhere and maximize his returns. The situation changes as the size of the corpus grows. Opportunities with high returns do not matter if he can deploy only a small portion of his capital. He would prefer that surplus capital is reinvested in the business, even if it earns only a reasonable (as opposed to high) rate of return.
A change in preferences
For most of his investing career Warren Buffett focused on companies that would provide very high returns on capital and also return surplus capital back to him for allocation. That is the reason why he preferred insurance companies (they generate a lot of investible surplus) and See's candy (very capital efficient even though poor growth rate) during that time.
Today he owns utilities. In the 2009 AGM of Berkshire Hathaway, he said "Capital-intensive industries outside the utility sector scare me more. We get decent returns on equity. You won't get rich, but you won't go broke either." And recently he bought the railroad company Burlington Northern Santa Fe, actually seeking out a capital intensive industry! In an interview he said, "You spend money in this business regularly every day. You're spending a lot of money to repair track, add rolling stock, whatever it may be. So it's capital-intensive, and it is regulated, and it will continue to be regulated, and it will continue to be capital-intensive."
And yes, he expects much lower rate of return as a result. "Reasonable return is good enough. I mean, 50 years ago, I was looking for spectacular returns, but I can't get them (anymore). We have US$ 8 or 10 bn to invest every year...And we should get a decent return on that....We're not entitled to spectacular returns."
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