Getting Rich by Investing in an Excellent Business

The Quality of a Company Can Heavily Influence Your Overall Investment Results

Investing in Excellent Businesses in Your Portfolio
••• Some businesses are better than others. Those tied to commodities - such as chicken - are never gone to be as good, as a class, as those that have some sort of protected trademark. For example, Coca-Cola can manufacture its syrup for a few pennies and sell it for much higher even in the midst of a Great Depression. Lester Lefkowitz / Stone / Getty Images

One of the most pleasing things about being a long-term investor is that history has demonstrated time and time again that the rewards of owning an excellent business in a tax-efficient manner can be positively 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 here this and wonder, “Yes, Joshua, but what is it that actually makes a company an excellent business?  How can I tell when I spot one?”

While that topic - how to find excellent businesses in which to invest - is a far more expansive than a single article could ever hope to cover (it would take years to fully explain, including a mastery of the income statement and balance sheet), to help you understand the traits of an excellent business, I’ve put together some resources that will give you an idea of what you should look for in a private business or when acquiring shares of stock.  I've also tried to include the reasons these things are important.

Armed with this information, over time, I believe 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.

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

There seems to be little doubt, based upon the evidence, that it’s easier 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 at a cheap must be sold when it reaches intrinsic value unless it is an excellent business. As Charlie Munger has pointed out, over long periods of time, the rate of return which 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.

For more information, read my article Business-Like Investing: Thinking Like an Owner.  In it, you'll find information on why return on capital matters so much.  A lot of people have gotten rich buying stocks that have sustainably high returns on equity.

You Want to Invest in Excellent Businesses That Have Durable Competitive Advantages

If you had unlimited funds, do you really believe that with the best 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 succeed so well is that they have durable competitive advantages – things that 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 being "okay". However, it is possible for these durable competitive advantages to remain buried, out of sight and out of mine. One of the secrets to the phenomenal success of Wal-Mart 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 cost resulted in far more profit on each item than his competitors could earn, even if those competitors were selling 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 but scores and scores of competitors out of business.  Eventually, anyone who wanted to remain in business on a large scale to compete against Wal-Mart 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.

You Want To Invest in Excellent Businesses That Are Scalable

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. I'm obsessed with scalability.  I adore it.  Take American Eagle Outfitters, which has one of the best long-term investment records over the past few decades. Why was it successful? Target? Wal-Mart? McDonald’s? Coca-Cola? Pepsi? Microsoft? All are excellent businesses in part because they had products or services that could be replicated in cookie-cutter fashion very, very rapidly.

 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. And New York. And Southern California. By having the menu, layout, fixtures, and technology packaged in a way that restaurants could be rapidly opened, 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, which footed the bill to build a huge portion of the overall business, it’s not hard to see why the shareholders consider Ray Kroc as a hero.

No Matter How Great the Business, When You Invest in a Company, Never Forget That Price Still Matters

In Price is Paramount: Investing in Excellent Businesses Isn't Enough, I explained to you that you still have to pay attention to how much you pay for your ownership.  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.  If there is nothing else you learn from my writings over the years, let that be it.  

Finally, as a parting note, I'd like to point out one interesting phenomenon.  Though it cannot guarantee success, and it's still possible to lose money, academic research has shown that a handful of industries historically have produced a disproportionate amount of aggregate investor wealth.  I wrote about some of the findings in an article called, appropriately enough, The Best Stocks Are Historically Found in a Handful of Industries.  At the very least, it's worth taking a look.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.