One of the most pleasing outcomes of being a long-term investor is that history has demonstrated that the rewards of owning an excellent business in a tax-efficient manner can be life-changing. This sentiment was summed up by legendary investors Warren Buffett and Charlie Munger at the 1996 Berkshire Hathaway meeting when they commented, “If you find three wonderful businesses in your life, you’ll get very rich. ” One year later, in 1997, Warren remarked, “The single biggest recurring mistake I’ve made has been my reluctance to pay up for outstanding businesses.”

As a new investor, you may hear this and wonder what actually makes a company an excellent business and how to spot one.

While that topic is expansive and difficult to condense, it’s not difficult to figure out what to look for in a private business or when acquiring shares of stock. Armed with this information, over time, you have a chance at being more successful in your quest to build a portfolio of wealth-generating assets that can provide financial independence and security for you and your family.

Invest In Excellent Businesses That Earn High Returns on Capital with Little or No Debt

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.

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 is an excellent business. As Charlie Munger has pointed out, 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 percent to 20 percent 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 of 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. 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 won from the increased income while consumers won from the 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 the largest retailer 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.

When you buy into a company through the purchase of its common stock, try to identify the durable competitive advantages it has that could stand up from attack by competitors and market forces such as outsourcing and increased globalization.

Invest in Excellent 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? What about Walmart? McDonald’s? Coca-Cola? Microsoft? All are excellent businesses in part because they had products or services that they could very rapidly replicate 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.

Think about it—the McDonald’s in Hong Kong is very much like the McDonald’s in Chicago or Southern California or Amsterdam. By having the menu, layout, fixtures, and technology packaged in a way that restaurants could be opened rapidly, it made it easier for the chain to steamroll across the United States and 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.

Never Forget That Price Still Matters

Imagine you buy the best business in the world and it earns $100,000 in real inflation-adjusted purchasing power each year. No matter what the economy, no matter what the political environment, it produces that $100,000 in real profit for you year after year, decade after decade. If you pay $1,000,000 for that business, your return is going to be double what it would be if you paid $2,000,000 for it. If you paid $10,000,000 for it, you’re going to suffer inferior returns. It’s that simple. The moment you write a check, the die is cast.

Everything from that point forward depends on the net present value of the cash flows you get from your asset and the price you paid to acquire that asset.

By Joshua Kennon, Managing director of Kennon-Green & Co.


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