Owning stock in a business you believe is excellent is a rewarding experience—both financially and personally. An excellent business is one that aligns with an investor's strategy, personal beliefs, risk tolerance, and reward goals. This means that one investor might believe a business to be excellent, while another may not.
As a new investor, you may hear this and wonder what actually makes a company an excellent business and how to spot one. This is an expansive topic and is difficult to condense—however, it's not difficult to figure out what to look for when you are looking to invest in a business.
When you invest in a business, you should look for at least four key factors:
- High returns on capital
- Competitive advantage
Invest in Businesses That Earn High Returns on Capital
It is certainly possible to build a large net worth through value investing—that is, the disciplined purchase of securities and other assets that appear to be selling at a substantial discount to a reasonable expert opinion of intrinsic value (or the "real" value of the business).
Think of it as if you knew a local car wash had gold buried underneath it. The proprietor might be asking $800,000 for the land and enterprise, but you know full well that you could pay substantially more, not only owning the business but also selling the gold you dug up on the open market. Thus, you had reason to believe that it was being sold for far less than its intrinsic value.
When choosing an investment, make sure you do your due diligence. Past performance is not always indicative of future performance.
The one major shortcoming of this approach is that an asset acquired on the cheap must be sold when it reaches its intrinsic value unless it meets your criteria for an excellent business. Over long periods, the rate of return that an investor earns is likely to be very close to the total return on capital generated by a firm, adjusted for dilution in shares outstanding.
Thus, you are likely to do better paying fair value for a business that can reinvest its capital at high rates of return—say, over 15% to 20% per annum—than buying a mediocre business trading at a small discount to its book value.
Look for Durable Competitive Advantages
If you had unlimited funds, do you really believe that with your pick of any manager in the world, you could unseat Coca-Cola as the undisputed leader in the soft drink industry? How about Johnson & Johnson with its myriad patents, trademarks, and brand name products? The reason these businesses are able to consistently succeed is that they have durable competitive advantages—they do things their competitors can’t reproduce.
Sometimes these advantages are easy to spot, as is the case of Coca-Cola, which is the second-most recognized word on Earth after "OK." However, it is possible for these durable competitive advantages to remain buried, out of sight and out of mind.
One of the secrets to the phenomenal success of Walmart is that Sam Walton built a distribution system with logistical capabilities that allowed him to lower the transportation costs of moving merchandise to his stores.
When you buy into a company through the purchase of its common stock, try to identify the durable competitive advantages it has that could withstand attack by competitors and market forces such as outsourcing and increased globalization, and economic swings throughout natural and man-made disasters and other crises.
These lower transportation costs resulted in far more profit on each item than his competitors could earn, even if those competitors sold at a higher price. He and his fellow shareholders benefitted from the increased income while consumers were rewarded with lower prices.
These forces worked in combination with one another, reinforcing and accelerating the results so much that the tiny five-and-dime grew into one of the largest retailers the world has ever seen, and put scores competitors out of business. Eventually, anyone who wanted to remain in business on a large scale to compete against Walmart had to have a comparably efficient supply chain.
Invest in Scalable Businesses
When businesses are highly successful and make their owners rich in a single generation, one of the key ingredients, more often than not, is scalability. Take American Eagle Outfitters, which has a strong long-term investment record over the past few decades. Why has it been successful? McDonald’s? Coca-Cola? Microsoft?
All are excellent businesses in part because they could very rapidly replicate products and services in cookie-cutter fashion. Once they got the base formula right, it could be rolled out and stamped across the country, and in many cases, the world.
Scalability refers to the ability of a business to adapt to consumer demands at low costs and short times.
The McDonald’s in Hong Kong is very much like the McDonald’s in Chicago, Southern California, or Amsterdam. By having the menu, layout, fixtures, and technology packaged in a way that allowed restaurants to be opened rapidly, it made it easier for the chain to steamroll across the United States and the globe.
Coupled with its relatively high returns on equity and the cash provided by the franchisees—who footed the bill to build a huge portion of the overall business—it’s not hard to see why shareholders revered Ray Kroc, founder of the McDonald's franchise business.
Price Still Matters
Even if you do your research and find a business you believe is the best in the world, you need to consider pricing. If your choice earns $100,000 in real inflation-adjusted purchasing power each year, no matter the economy or political environment, year after year, decade after decade—it is a great investment.
However, this depends on how much you pay for the stock. If you pay $1,000,000 for that stock and earned $100,000 a year on it, It would take you decades to recoup your initial investment. This goes up substantially the more you pay for an investment. If you paid $10,000,000 for it, you're going to suffer inferior returns—it could take an entire lifetime to earn it back.