It's simple to say that to earn strong returns, investors should be looking to buy the best businesses. But what qualities should one be looking for in the best businesses? Are there any qualities that should stand out or any factors investors should disregard when searching for the market's best companies?
There's no fixed answer to this question, but Charlie Munger (Trades, Portfolio) has given a great deal of commentary over the years, presenting his thoughts on what really makes a good business.
A lifetime of work
Munger's thoughts are captivating because he has spent a lifetime studying and working in businesses. As an investor, director, lawyer and avid reader, I don't think there are many business situations the billionaire investor hasn't encountered at some point. This experience has enabled the investor to build a mental framework of what works and what doesn't when investing.
In a recent meeting of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders, when asked how the company goes about finding potential acquisition candidates, Munger provided the following checklist:
"We're light on financial yardsticks; we apply lots of subjective criteria: Can we trust management? Can it harm our reputation? What can go wrong? Do we understand the business? Does it require capital infusions to keep it going? What is the expected cash flow? We don't expect linear growth; cyclicality is fine with us as long as the price is appropriate."
This is an excellent insight into the process he uses to evaluate securities. Rather than focusing on simple financial metrics, it would appear as if the billionaire investor has always focused on the qualitative factors, with some rough estimations of cash flow added into the equation.
And the strength of the company's competitive advantage is another significant factor Munger always considers when reviewing a potential investment opportunity. These companies are few and far between:
"There are actually businesses that you will find a few times in a lifetime where any manager could raise the return enormously just by raising prices— and yet they haven't done it. So they have huge untapped pricing power that they're not using. That is the ultimate no-brainer. That existed in Disney (DIS, Financial). It's such a unique experience to take your grandchild to Disneyland. You're not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot, and the attendance stayed right up…"
Circling back to some of the qualities highlighted in the first quote, Munger has also said that companies that can return capital to investors are by far the better investments:
"There are two kinds of businesses: The first earns 12%, and you can take the profits out at the end of the year. The second earns 12%, but all the excess cash must be reinvested— there's never any cash. It reminds me of the guy who sells construction equipment— he looks at his used machines, taken in as customers bought new ones, and says, 'There's all of my profit, rusting in my yard.' We hate that kind of business."
Building a framework
Combining these three quotes gives us a robust framework for finding good investments. Based on these comments, I have pulled out seven potential questions that investors might want to ask before investing in a company, forming a checklist based on Munger's observations and experience:
- Can we trust management?
- What can go wrong?
- Do we understand the business?
- Does it require capital infusions to keep it going?
- What is the expected cash flow?
- Does it need to invest heavily in inventory and capital projects?
- Can it raise prices without losing customers?
There's no guarantee these criteria will help find the market's best stocks, but they will almost certainly help filter out the bad and mediocre companies.
