Reflections On The Nature and Characteristics of Superior Businesses

This list is was generated by reviewing personal notes during operating experience and a compiled set of notes from public information shared by Berkshire Hathaway. This article seeks to define the key characteristics which make the best type of businesses to own, operate or invest in.

“A dollar earned from a horseshoe company is the same as a dollar earned from an internet company”.

Warren Buffet - 1999

• Requires No Additional Capital To Grow
  • “[The] Ideal business takes no capital and grows” – Warren Buffett
    
• High Returns On Capital ( Incremental Or Otherwise )
  • “Have a few businesses that get 100% return on capital” – Warren Buffet
  • Each additional dollar poured back into the business produces more than a dollar.
  • High Returns on Tangible Assets - even companies with narrow margins that have a high return on capital can do well.
    
• Durable Competitive Advantage That Will Last 5-10 Years At A Minimum ( Moat )
  • How easily can their competitive advantage be competed away
  • Management is a factor into the Moat of a business
    • “The moat and the management are part of the valuation process, in that they enter into our thinking as to the degree of certainty that we attribute to the stream of income — stream of cash, actually — that we expect in the future and the amount of it. I mean it is, you know, it is — it’s an art, in terms of valuation of businesses. The formulas get simple at the end.” – BRK Annual Meeting - 1999
• Low Competition For An Extended Period
  • How much price competition will enter and in what time frame?
    
• High Barriers Of Entry
  • Example: Patents on manufacture specialty equipment
    
• Economics of Scale
  • Purchasing power can lead to pricing power and operational redundancy
  • Scale of market dominance
  • Scale of intelligence
    
• A Low-Cost Producer Of An Essential Item
  • “Being a low-cost producer of an essential thing is going to work well generally.” – WB 2004
    
• High Return On Net Tangible Assets
  • Specifically, look at the return on net tangible assets in terms of evaluating a good/bad/great business. Higher is always better.
    
• Good Will – Strong Brands But No Premium For It
  • In evaluating the business, forget about goodwill in assessing economics of the business and only factor it into the math of the purchase transaction.
    
• (A) Capital Light – Does Not Require Significant Capital To Run
  • Doesn’t need to spend incrementally more capital in subsequent years just to maintain its position.
  • Doesn’t need to spend a lot on capital to buy more equipment (ex: equipment leasing)
    • Depreciation expenses are real expenses that need to be paid back into the business.
  • “On balance if you can find a business that is not capital intensive vs one that is capital intensive you will be better off over time” – WB
    
• (B) Capital Light – No major continuing depreciation expenses consuming capital
  • “Depreciation is the worst kind of expense !” – WB 2003
    • “So, it — depreciation is real, and it’s the worst kind of expense. It’s reverse float. You know, you lay out the money before you get revenue. And you are out cash with nothing coming in.” …

We, at Berkshire, will spend more than our depreciation this year. We spent more than our depreciation last year. We spent more than our depreciation the year before that. You know, depreciation is a real expense, just as much as, you know, the expenditure for lights.

It’s not a non-cash expense. It’s a cash expense. You just spend it first, you know. I mean the cash is gone, and it’s a delayed recording of cash. How anybody can turn that into something they use as a metric that talks about earnings is beyond me.”
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-WB 2003

• Does Not Require Debt Leverage To Operate
  “‘Anything can happen in markets’…‘The only real way smart people can get clobbered is with leverage and not having enough liquidity’
  If you look at the record of the 20th century, you’d say how can anybody have missed, you know, in owning equities during that time? And yet, you know, we had all kinds of people wiped out, you know, in the ’29-’32 period. We had all kinds of things that were bad.
  
  But if you had just owned stocks right straight through, didn’t leverage them, you know, you would — you’d have gotten a perfectly decent return.”
  - WB 2004 Annual Meeting
  • Want situations where you don’t accidentally do something dumb (with debt)
    • “ Really, the only way a smart person that’s reasonably disciplined in how they look at investments can get in trouble is through leverage. I mean, if somebody else can pull the plug on you during the worst moment of some kind of general financial disaster, you go broke. And Charlie and I both have friends that have — where that’s happened to them. But absent leverage, and absent just kind of going crazy in terms of valuation on things, the world won’t hurt you over time in securities.” - WB 2004
• History of Distributions and Drowns in Cash
  • Want a business that drowns in Cash but not enough places to put it.
  • Need to understand the financial statements, the economics of the business and specific industry.
  • Construction equipment businesses are not the types of businesses that drown in cash.
  • Sees’ Candy is a great business by contrast ( a confectionary business can be great )
    • “The very best businesses, the really wonderful businesses, require no book value. They — and we are — we want to buy businesses, really, that will deliver more and more cash and not need to retain cash, which is what builds up book value over time.” – WB Annual 2000

• Labor & Labor Competition Stability & Structure
  • Businesses that can survive long labor strikes will not get in trouble
    1. Businesses that can’t survive a long labor strike will get in trouble
       1. ‘Ironically the weaker position you are in as a business the more power you have because it will put you out of business’ - WB
  • “ Don’t focus on world trends – think about foreign competition (don’t think about something with a very high labor content that can get shipped in later) [think Dexter shoes – which was competed away because of low-cost foreign labor]”- WB
    
• High Return on Equity
  • Management understands the dilutive power of issuing shares and prefers buybacks over dividends.
     
• Able Management
  • Understand ROE / ROIC / Opportunity cost / Conservative use of cash
  • Management understands the value of R/E deployed at high rates of return relative to other options; broadly, opportunity cost.
  • Buy great businesses with good managers in place
  • Enough expert intelligence that the leader has an advantage in a field (harder to stay smart).
  • Identifying good managers:
    • Integrity is the most important variable
    • Want continuing management who just wants to monetize their business
      • Continue to support what they love
      • Love of the business more than love of money
    • People that created (founders) of the businesses are generally better than people that bought in a few years ago
    • Intelligence
    • Energy
    • Want someone who has a business they have run for 10-15 years and make the assumption that they won’t screw it up going forward
    • Wants to work until they die
    • Roughly - People who started businesses much younger in life had better success metrics
    • Someone who has the right temperament as a leader
    • “We don’t want to buy something where we feel we can run it better than the person who owns it”. Management that can continue to run it.
      • But still want a business that a ham sandwich can run
    • The most quality in a person is the person who is going to be effective – and the other habits that want you to be a person that you want to follow
    • Don’t care about the Mid/Small/Large cap as a function of size– focus more on culture of management and institution to make a buy decision. Management must  understand the microeconomics of the business
    • Avoid institutional stupidity
      
• Simple Economics
  • Have to understand the predictability of the economics of the business 10 years out.
  • Business’ economics must be clearly comprehensible

• Honest Management
  • “Never let the people who are making a ton of money be deluded by their own success and also mislead you” – Charlie Munger
  • “Managers who love the business more than they love the money” – WB 2000
  • Companies must be intellectually honest with themselves
    • “We want people joining us who already are the type that face reality and that tell us, basically, tell us the truth but tell themselves the truth, which is even more important. Not correctable in the lifespan of humans.” – BRK Meeting 2000
    • {They go on to state that this problem is exaggerated in - finance-related businesses; implying that if there is a small problem it is probably a huge problem.}
  • “We don’t invest in any company that talks about EBIDTA” – Annual meeting
    • Taxes are a real expense
    • Depreciation is the worst kind of expense
    • There are very few companies that don’t talk about EBIDTA, focus on those.
      
• Customers Provide Financing
  • Ex: periodicals, newspapers
    
• Consumers or Businesses Spend Of Current Income To Acquire Its Good Or Service
  • Something people are willing to give a portion of their present income to acquire:
    “ The second best hedge is to own a wonderful business, not a metals business, necessarily, not a raw material business, not a minerals business, but a wonderful business.  
    And the truth is, if you own Coca-Cola, if you own Snickers bars, if you own Hershey bars, if you own anything that people are going to want to give a portion of their current income to keep getting, and it has relatively low capital investment attached to it so that you don’t have to keep plowing tremendous amounts of money in just to meet inflationary demands, that’s the best investment you can probably have in an inflationary world.
    But inflation is bad news for investors under almost any circumstances.
    You can argue that if you own some business that required very little capital investment and had real flexibility of price during an inflationary period so that people would continue to give up a half an hour of work — of their own work — every month to buy your product, and you leveraged it, then you might even beat inflation to some extent.  – WB 2007

• Easy Decision Making For The Use Of Capital Within The Business
  • If management has to guess where to deploy capital then it is much more difficult to grow.
  • Professional service businesses often have these characteristics.
    
• Pricing Power
  • Minimum: Can raise prices at least at rate of inflation
  • Ideal: can raise prices well ahead of inflation year over year

“ And it’s not a great business when you have to have a prayer session before you raise your prices a penny. I mean, you were in a tough business then.

You can learn a lot about — you learn a lot about the durability of the economics of a business by observing the behavior of — the price behavior.

You want a business that keeps its money in real dollars during periods of high inflation and doesn’t require big capital investment to stay current.” – 2005

• “The best business is HBS / Stanford – the more they raise the price the more people want to get in….It increases demand, the more they think the product is worth.” – [Implication being there is no appreciable additional value for what you pay]WB 2000 Annual meeting
  
• Operations Will Not Change In 10+ Years
  • “We look at change as a threat – we want a company to operate the same in 10 years.” – 1999 meeting
  • “ Businesses with Rapid Change you want to avoid ” – WB 2001
  • “ Charlie would say it is getting harder ” – WB 2001
  • “ & Some moats are getting filled in ” - CM 2001

• Strong distributable earnings in times of inflation - Can produce cash when inflation is high
  
• Steady shares outstanding - no need to or history of issuing new shares and the ability to regularly buy them back
  
• Has A Strong Brand
  • “Most of the big food companies are good businesses…It’s not easy to unseat these products. Branded products that are runaway leaders in their fields.” – WB 2008
  • ‘Businesses with good intangible assets (but not accounted for in the cost) will be helpful’- WB
    
• No Uncertainty Risk That Would Apply To The Broader Organization
  • Want to avoid businesses where you'd take on an unnecessary risk that would apply to the broader organization:
    • ex: TSA guards at gates in the case of 9/11
    • Or providing better helmets to motorcyclists
      
• Natural Monopoly
  • The largest newspaper in a given town
  • Google’s single dataset for search
    
• Definable Unknowns That Don’t Pose Major Risks

Note on companies with commodity characteristics

1. Commodities companies (labor or materials) generally do not fit the characteristics of a good business.
   • Warren Buffet and Charlie Munger have been on record stating that they cannot calculate the macroeconomic probability of commodity price stability or growth. It is too difficult.
   • The underlying assets can generally be evaluated in terms of comparable value.
   • Incentives for management should be based on lowering the price of what is produced over time be it mineral rights or forest products etc.
2. Labor businesses can extend to a variety of industries
   • Textiles, shoes, low skilled production businesses that is easily substituted with lower cost often fit this mold.
   • Large scale services business (accounting, engineering, etc) tend over long periods of time to mirror the characteristics of commodity businesses.

Unfavorable Characteristics:

1. Dishonest Management Or Not Intellectually Honest Management
2. Low Or No Return On Capital
3. Low Or No Return On Equity
4. Low Or No Return On Assets
5. Capital Intense – requires lots of additional capital to grow or maintain its present position.
   • “Capital intensive businesses outside of utilities [are bad] .”- WB
     • “Most fields that require heavy capital investment, most of the time, they don’t turn out very well over time. There are plenty of exceptions to that. But if you find a business that has to keep adding up huge sums of money every year, there always will be a reason why they’re doing it. But the net result, after five or 10 or 20 years usually isn’t very good.”  – WB 2000 Annual Meeting

• Businesses that suck in capital create contention between the people that work there and the capital needs of the business
  • Contracts will not allow capital (people) to receive any sort of compensation – but you have the same tension in a service business. Changing a culture around this takes time and takes some change in people. It’s a great surprise if you can do it.
    • There are people that will buy into this arrangement and many who won’t.
    • Some people leave people-based firms (Such as Solomon and Goldman) because they can make more money -elsewhere with capitalism.  They are everywhere on Wallstreet – it comes with the territory of the business.Everyone is going to have a bad year from time to time.
      
• Declining Industry
  • Print Newspapers in the US in the present market.
    
• Declining Earnings
  • ‘Don’t pay for a business that has earnings that is going to go down 5-6% a year in earnings –Companies generally are not cheap enough to compensate for the decline. EX newspaper businesses.’ – Annual Meeting
    
• No Or Low Pricing Power Or No Ability To Create It
• Average Businesses
• Business Provides Financing To Customers
• Not Able To Distribute Capital To Their Owners
• High Receivables And Large Amounts Of Inventory
  • 'receivables and inventories and all of that.'
  • “And in dollar terms, if their volume stays flat but the price level doubles, and they need to come up with double the amount of money to do that same volume of business, that can be a very bad asset.”
• Size – Too Small
  • Small businesses that don’t have the ability to become big
  • Retailing in general is really hard on average to create earning power
• ‘Frozen’ Businesses
• Businesses Requiring Unusual Human Skill That Can’t Be Replicated
• Business facing disruption
  • Consider how the internet will affect the business over time.
  • It will reduce the profitability of American businesses in aggregate due to direct and unlimited competition. 
    

Simplified Checklist Process for Considering The Purchase Of All Or Part Of A Business:

1. Understandable Business
   • Can you clearly understand the business and everything about it?
     
2. Favorable Long-Term Economics (Moat)
   • Will the business have survivorship over a 10+ year period? And other characteristics defined above.
   • How risky is the business? Could there be permanent equity loss? Will it be a low performer?
   • Apply the criteria above regarding favorable and unfavorable characteristics to make a determination as to the nature of the business.
     
3. Able And Trustworthy Management
   • Yes or No requirement
     
4. A Sensible Price Tag
   • Want a margin of safety in the purchase price (30%) – if not move onto the next opportunity based on which business will have the highest ROIC for a long time
     • Comparable ROIC serves as the primary opportunity cost metric following price
   • Return profile – want at least 10% return for a large business (not including the margin of safety)
   • Look at GDP to prices / interest rates / ROE / ROIC
     • Equities can sometimes be valued like wheat or Rembrandts – when you get Rembrandt prices – this can go on for a long time – CM
     • Increases in savings will drive down the return on capital – WB
   • Don’t focus too much on each variable – but err be on the conservative side
   • Be conservative with each variable then have a significant margin of safety at the end
   • Don’t look at items with extreme assumptions for any one variable
   • Contrast the purchase decisions against all purchase and sales decisions in the past

Appendix: Discussions on The Best Types of Businesses from Berkshire Hathaway Annual Meetings

Avoid the “Frozen Corporation”

AUDIENCE MEMBER: Good afternoon, gentlemen. My name is George Donner from Fort Wayne, Indiana.

My question has to do with estimating the intrinsic value of a company, in particular the capital intensive companies like you were mentioning. I’m thinking of things like McDonald’s and Walgreens, but there are lots of others where you have a very healthy and growing operating cash flow, but it’s marginally or completely offset by heavy expenditures on putting up new stores or restaurants, or building a new plant.

And so my question is, what do you do for your estimate of future free cash flow? And with Treasurys around — long Treasurys around 6 percent — at what rate do you discount those cash flows?

WARREN BUFFETT: Well, we discount at the long rate just to have a standard of measurement across all businesses. But we would take the company that is spending the money as it comes in, and they don’t get credit for gross cash flow, they get credit for whatever net cash is left every year.
But of course, if they’re spending the money wisely, even though you have to discount it for more years, the growth in cash development should offset that or they weren’t investing it wisely.
The best business is one that gives you more and more money every year without putting up anything to get it, or very little. And we’ve got some businesses like that.
The second-best business is a business that also gives you more and more money. It takes more money, but the rate at which you invest — reinvest — the money to get that growth is a very satisfactory rate.
The worst business of all is the one that grows a lot, and where you’re forced — forced, in effect — forced to grow to stay in the game at all, and where you’re reinvesting the capital at a very low rate of return. And sometimes people are in those businesses without knowing about it.
But in terms of discounting, in terms of calculating intrinsic value, you look at the cash that is expected to be generated and you discount back at — in our case, we use the long-term Treasury rate. That doesn’t mean that you pay the amount that that present value calculation leads to, but it means that you use that as a common yardstick, that Treasury rate.
And that means that if somebody is reinvesting all their cash flow the next five years, they’d better have some very big figures coming in down the road. Because at some day, a financial asset has to give you back cash to justify you laying out cash for it now.
Investing is the art, essentially, of laying out cash now to get a whole lot more cash later on, and something at some point better deliver cash.
Ben Graham in his class, we used to talk about what he called the Frozen Corporation. And the Frozen Corporation was a company whose charter prohibited it from ever paying anything to its owners, or ever being liquidated, or ever being sold and —
CHARLIE MUNGER: Sort of like a Hollywood producer. (Laughter)
WARREN BUFFETT: Yeah. And the question was, what was such an enterprise worth? Well, that’s sort of a theoretical question, but it forces you to think about the realities of what business is all about. And business is all about putting out money today to get back more money later on.
Charlie?
CHARLIE MUNGER: I do think there is an interesting problem that you raise, because I think there is a class of businesses where the eventual cash back part of the equation tends to be an illusion. I think there are businesses where you just keep pouring it in and pouring it in, and then all of a sudden it doesn’t work, and no cash comes back.
And what makes our life interesting is trying to avoid those and get in the alternative kind that drowns you in cash. (Laughter)
WARREN BUFFETT: The one figure we regard as utter nonsense is the so-called EBITDA. I mean, the idea of looking at a figure before the cash requirements and merely staying in the same place — and there usually are — any business with significant fixed assets almost always has with it a concomitant requirement that major cash be reinvested in order simply to stay in the same place competitively and in terms of unit sales — to look at some figure that is before — that is stated before those cash requirements, is absolute folly and it’s been misused by lots of people to sell lots of merchandise in recent years.
CHARLIE MUNGER: It’s not to the credit of the investment banking fraternity that it has learned to speak in terms of EBITDA. I mean, the idea of using a measure that you know is nonsense, and then piling additional reasoning on that false assumption, it’s not creditable intellectual performance. And then once everybody is talking in terms of nonsense, why, it gets to be standard. (Laughter)

Checklist for selecting stocks ( Businesses ) - Could you explain the criteria you look at when selecting your stocks?

WARREN BUFFETT: Well, we look at — I’m glad you came. I hope there’s a large group. I got a note, I think from your teacher, on that. (Applause)
We look at it — the criteria for selecting a stock is really the criteria for looking at a business. We are looking for a business we can understand. That means they sell a product that we think we understand, or we understand the nature of the competition, what could go wrong with it over time.
And then when we find that business we try to figure out whether the economics of it means the earning power over the next five, or 10, or 15 years is likely to be good and getting better or poor and getting worse. But we try to evaluate that future stream.
And then we try to decide whether we’re getting in with some people that we feel comfortable being in with.
And then we try to decide what’s an appropriate price for what we’ve seen up to that point.
And as I said last year, what we do is simple but not necessarily easy.
The checklist that is going through our mind is not very complicated. Knowing what you don’t know is important, and sometimes that’s not easy. And knowing the future is definitely — it’s impossible in many cases, in our view, and it’s difficult in others. And sometimes it’s relatively easy, and we’re looking for the ones that are relatively easy.
And then when you get all through you have to find it at a price that’s interesting to you, and that’s very difficult for us now. Although there have been periods in the past where it’s been a total cinch.
And that’s what goes through our mind. If you were thinking of buying a service station, or a dry cleaning establishment, or a convenience store in Omaha to invest your life savings in and run as a business, you’d think about the same sort of things.
You’d think about the competitive position and what it would look like five or 10 years from now, and how you were going to run it, and who was going to run it for you, and how much you had to pay.
And that’s exactly what we think of when we look at a stock, because the stock is nothing other than a piece of a business.
Charlie?

Easy decision case study: National Cash Register

CHARLIE MUNGER: Yeah. If finance were — when finance is properly taught, it should be taught from cases where the investment decision is easy.
And the one I always cite is the early history of National Cash Register Company, and that was created by a fanatic who bought all the patents, and had the best salesforce, and the best production plants. He was a very intelligent man and passionately dedicated to the cash register business.
And of course, the cash register business was a godsend to retailing when cash registers were invented. So that was the pharmaceuticals of a former age.
If you read an early annual report prepared by Patterson, who was CEO of National Cash Register, an idiot could see that this was a talented fanatic. Very favorably located, and that, therefore, the investment decision was easy.
If I were teaching finance, I would collect a hundred cases like that. And that’s the way I would teach the students.
WARREN BUFFETT: We have that annual report. What was that, 1904 or something, Charlie?
But it’s really a classic report because Patterson not only tells you why his cash register is worth about 20 times what he’s selling for to people, but he also — (laughs) — tells you that you’re an idiot if you want to go in competition with him. It’s a classic.
CHARLIE MUNGER: It is just a (inaudible). But no intelligent person can read this report and not realize — (laughs) — that this guy can’t lose.

 “Norman Rockwell frame of mind”

AUDIENCE MEMBER: Good afternoon. My name is Robert Rowland (PH) from London, England.

I’ve been in Omaha all weekend with my wife on the first leg of my honeymoon, and I’ve noticed you’re quite a buyer of nostalgic assets. Can I ask whether nostalgia is one of your filters? (Buffett laughs)

Are there any assets like that left in the U.S. to buy? And if not, can I suggest you come to the U.K. where all we do is sell them? (Laughter)

WARREN BUFFETT: Well, I don’t want to interrupt your honeymoon. (Laughter)
But if you’d send me a list of those companies over there that are long on nostalgia, that might be to our liking. Because Charlie and I tend to operate from sort of a Norman Rockwell frame of mind. And it is true that the kind of companies we like sort of do have a homey, Norman Rockwell, Saturday Evening Post-type character to them there.
They have character. And they’re the kind of companies, I think, frequently, that people, when they join them, expect to spend the rest of their lives there rather than look at it as something to stick on their resume.
And there are businesses like that. If you look at the businesses that we’ve bought in the last three or four years, there is real character to the businesses and to the people that build them.
And that’s why the people that build them stay on and feel very strongly about running them correctly, even though they have no financial consequence to themselves whatsoever, so —
If you’ve got a list of those in England and you still have any strength left after your honeymoon, drop me a line. (Laughter)

High ROIC, ROE, Honesty -  Beware of companies that must “spend money like crazy”

AUDIENCE MEMBER: My question has to do with what you mentioned earlier about how companies have to reinvest a certain amount of cash in their business every year just to stay in place.

And if one could say that the best businesses are the ones that not only throw off lots of cash, but can reinvest it in more capacity. But I suppose the paradox is that the better a company’s opportunities for making expansionary capital expenditures, the worse they appear to be as consumers of cash rather than generators of cash.

What specific techniques have you used to figure out the maintenance capital expenditures that you need to do in order to figure out how much cash a company is throwing off? What techniques have you used on Gillette or other companies that you’ve studied?

WARREN BUFFETT: Well, if you look at a company such as Gillette or Coke, you won’t find great differences between their depreciation — forget about amortization for the moment — but depreciation and sort of the required capital expenditures.
If we got into a hyperinflationary period or — I mean, you can find — you can set up cases where that wouldn’t be true.
But by and large, the depreciation charge is not inappropriate in most companies to use as a proxy for required capital expenditures. Which is why we think that reported earnings plus amortization of intangibles usually gives a pretty good indication of earning power, and —
I don’t — I’ve never given a thought to whether Gillette needs to spend a hundred million dollars more, a hundred million dollars less, than depreciation in order to maintain its competitive position. But I would guess the range is even considerably less than that versus its recorded depreciation.
Businesses you have to worry about — I mean, an airline business is a good case. In the airlines, you know, you just have to keep spending money like crazy. And you have to spend money like crazy if it’s attractive to spend money, and you have to spend it the same way if it’s unattractive. You just — it’s part of the game.
Even in our textile business, to stay competitive we would’ve needed to spend substantial money without any necessary — any clear prospects of making any money when we got through spending it.
And those are real traps, those kind of businesses. And they make out one way or another, but they’re dangerous. And in a See’s Candy we would love to be able to spend 10 million, 100 million, $500 million and get anything like the returns we’ve gotten in the past.
But there aren’t good ways to do it, unfortunately. We’ll keep looking, but it’s not a business where capital produces the profits.
At FlightSafety, capital produces the profits. You need more simulators as you go along, and more pilots are to be trained, and so capital is required to produce profits. But it’s just not the case at See’s.
And at Coca-Cola, particularly when new markets come along, you know, the Chinas of the world or East Germany or something of the sort, the Coca-Cola Company itself would frequently make the investments needed to build up the bottling infrastructure to rapidly capitalize on those markets, the old Soviet Union.
So those are — those are expenditures — you don’t even make the calculation on them, you just know you’ve have to do it. You got a wonderful business, and you want to have it spread worldwide, and you want to capitalize on it to its fullest.
And you can make a return on investment calculation, but as far as I’m concerned it’s a waste of time because you’re going to do it anyway, and you know you want to dominate those markets over time. And eventually, you’ll probably fold those investments into other bottling systems as the market gets developed. But you don’t want to wait for conventional bottlers to do it, you want to be there.
One of the ironies, incidentally — and might get a kick out of it, some of the older members of the audience — that when the Berlin Wall went down and Coke was there that day with Coca-Cola for East Germany, that Coke came from the bottling plant at Dunkirk. So there was a certain poetic — (crowd noise) — irony there.
Charlie, do you have anything on this?
CHARLIE MUNGER: I’ve heard Warren say since very early in his life that the difference between a good business and a bad business is usually the good business just throws up one easy decision after another, whereas the bad business gives you a horrible choice where the decision is hard to make and, is this really going to work? And is it worth the money?
If you want a system for determining which is a good business and which is a bad business, just see which one is throwing the management bloopers time after time after time.
Easy decisions. It’s not very hard for us to decide to open a new See’s store in a new shopping center in California that’s obviously going to succeed. It’s a blooper.
On the other hand, there are plenty of businesses where the decisions that come across your desk are just awful. And those businesses, by and large, don’t work very well.
WARREN BUFFETT: I’ve been on the board of Coke now for 10 years, and we’ve had project after project come up, and there’s always an ROI. But it doesn’t really make much difference to me, because in the end almost any decision you make that solidifies and extends the dominance of Coke around the world in an industry that’s growing by a significant percentage, and which has great inherent underlying profitability, the decisions are going to be right and you’ve got people there that will execute them well.
CHARLIE MUNGER: You’re saying you get blooper after blooper.
WARREN BUFFETT: Yeah. And then Charlie and I sat on USAir, and the decisions would come along, and it would be a question of, you know, do you buy the Eastern Shuttle, or whatever it may be?
And you’re running out of money. And yet to play the game and to keep the traffic flow with connecting passengers, I mean, you just have to continually make these decisions — whether you spend a hundred million dollars more on some airport.
And they’re agony because, again, you don’t have any real choice, but you also don’t have any real conviction that it’s going to translate — those choices are going to — or lack of choices — are going to translate themselves into real money later on.
So one game is just forcing you to push more money in to the table with no idea of what kind of a hand you hold, and the other one you get a chance to push more money in, knowing that you’ve got a winning hand all the way.
Charlie? Why’d we buy USAir? (Laughter)
Could’ve bought more Coke.

Many Great Businesses Can’t Boost Profits By Spending More Capital (2003)

AUDIENCE MEMBER: Hi there. My name is Alex Rubalcava. I am a shareholder from Los Angeles.

I have a question about the financial characteristics of the businesses that you like to acquire and invest in.

In your reports and other writings, Mr. Buffett, you state that you like to acquire businesses that can employ a large amount of capital to high returns.

And in reading the writings and speeches of yourself, Mr. Munger, I’ve seen you say in Outstanding Investor Digest and other publications, that you enjoy investing in companies that require very little capital.

And I was wondering if these statements are at odds, or if they are two sides of the same coin? And if you could elaborate using Berkshire companies, that would be great.

WARREN BUFFETT: Sure. It’s a good question.
The ideal business is one that earns very high returns on capital and could keep using lots of capital at those high returns. I mean that becomes a compounding machine.
So if you have your choice, if you could put a hundred million dollars into a business that earns 20 percent on that capital — say 20 million — ideally, it would be able to earn 20 percent on 120 million the following year, and 144 million the following year and so on. That you could keep redeploying capital at these same returns over time.
But there are very, very, very few businesses like that. The really — unfortunately, the good businesses, you know, take a Coca-Cola or a See’s Candy, they don’t require much capital.
And incremental capital doesn’t produce anything like the returns that this fundamental return that’s produced by some great intangible.
So we would love the business that earn — that could keep deploying, in fact, even well beyond the earnings. I mean we’d love to have a business that could earn 20 percent on a hundred million now. And if we put a billion more in it, it would earn 20 percent more on that billion.
But like I say, those businesses are so rare. There are a lot of promises of those businesses, but we’ve practically never seen one. There’ve been a few.
Most of the great businesses generate lots of money. They do not generate lots of opportunities to earn high returns on incremental capital.
You know, we can deploy X at See’s and earn a lot of money, but if we put 5X in we don’t earn any more money to speak of. We can earn high returns on X at The Buffalo News, but if we try to make it 5X we don’t earn any more money.
They just don’t have the opportunities to use incremental capital. We look for them, but they don’t.
So, the great — you’ve seen — I mean, we will talk theoretically about the businesses that can earn more and more money with incremental capital at high returns.
But what you’ve seen is that we’ve bought businesses, largely, that earn good returns on capital, but in many cases, have limited opportunities to earn anything like the returns they earn on their basic business with incremental capital.
Now, the one good thing about our structure at Berkshire is that we can take those businesses that earn good returns in their business but don’t have the opportunity for returns of those similar magnitude on incremental money, and we can move that money around to buy more businesses.
Normally, if you’re in the — take the newspaper publishing business, which has been a fantastic business over the years — you earned terrific returns on your own invested capital.
But if you went out to buy other newspapers, you had to pay a very fancy price, and you didn’t get great returns on incremental capital.
But the people in that business felt that the only thing they knew was newspaper publishing or media of one sort or another, so they felt that their options were limited.
We can move money anyplace that it makes sense, and that’s an advantage of our structure. Now, whether we do a good job of it or not’s another question, but the structure is enormously advantageous in that respect.
We can take the good business, the See’s Candy — See’s has produced probably a billion dollars pretax for us since Charlie and I wouldn’t have gone up 100,000, you know, back in 1972.
If we tried to employ that in the candy business we’d have gotten terrible returns over time. We would have gotten anything to speak of. But because we moved it around it enabled us to buy some other businesses over time, and that’s an advantage of our structure.
Charlie?
CHARLIE MUNGER: Yeah. And if you take a business that is a good business, but not a fabulous business, they tend to fall into two categories.
One is the business where the whole reported profit just sits there in surplus cash at the end of the year. And you can take it out of the business and the business will do just as well without it as it would if it stayed in the business.
The second business is one that reports the 12 percent on capital but there’s never any cash. It reminds me of the used construction equipment business of my old friend, John Anderson. And he used to say, “In my business, every year you make a profit, and there it is, sitting in the yard.”
And there are an awful lot of businesses like that, where just to keep going, to stay in place, there’s never any cash.
Now, that business doesn’t enable headquarters to drag out all the cash and invest it elsewhere. We hate that kind of a business. Don’t you think that’s a fair statement?
WARREN BUFFETT: Yeah, that’s a fair statement. We like to be able to move cash around and have it find its best use. And, you know — but that’s our job. And sometimes we find good uses.
It would be terrific if every one of our great businesses, and we’ve got a lot of great businesses, had ways to deploy additional capital at great rates, but we don’t see it.
And, frankly, you know, it doesn’t happen — I mean Gillette has a great razor and blade business, I mean, fabulous.
There’s no way they can deploy the money they make in the razor and blade business to keep putting more money in that kind of business. It just doesn’t take that kind of capital. They have to deploy some money of it, but it’s peanuts compared to the profits.
And the temptation then is to go out and buy other businesses, and of course that’s what Charlie and I do when we face that, but we don’t think that, overall, the batting average of American industry in redeploying capital has been great. Nevertheless, it’s what we try and do every day.
In a sense, we sort of knock the very procedure that has gotten us to where we are. Is that a fair statement, Charlie? (Laughs)
CHARLIE MUNGER: Absolutely. And that has always worried me. I don’t like being an example of an activity where most people who try and follow it will get terrible results. And we try and avoid that by making these negative comments. (Laughter)
WARREN BUFFETT: We’d make negative comments anyway. (Laughs)
Number 5. It’s more fun.

Good, But Not Brilliant, Returns For Businesses Needing Capital (2010)

AUDIENCE MEMBER: Hi, I’m Steve Fulton (PH) from Louisville, Kentucky. Once again, I gave up a box seat to the Kentucky Derby to come ask you a question. (Laughter)

And I appreciate that opportunity.

My question’s focused on the shift, if you will, to investing in the capital-intensive businesses and the related impact on intrinsic value.

You again stated in the annual report that best businesses for owners are those that have high returns on capital and require little incremental capital.

I realize this decision is somewhat driven by the substantial amounts of cash that the current operating companies are spinning off, but I would like you to contrast the requirement for this capital against the definition of intrinsic value, which is the discounted value of the cash that’s being taken out.

And just for all of us to be aware, you’ve mentioned the fact that you think these businesses will require tens of billions of dollars over the few decades, and just the time value of that, I’d like to understand a little bit more of your insight into that.

WARREN BUFFETT: OK. Although it’s clear you understand the situation quite well, and it’s — as important a question as you could ask, virtually, I would say, at Berkshire.
We are putting money into good — big money — into good businesses from an economic standpoint. But they are not as good as some we could buy when we were dealing with smaller amounts of money.
If you take See’s Candy, it has 40 million or so of required capital in the business, and, you know, it earns something well above that.
Now, if we could double the capital, if we could put another 40 million in at anything like the returns we receive on the first 40 million, I mean, we’d be down there this afternoon with the money.
Unfortunately, the wonderful businesses don’t soak up capital. That’s one of the reasons they’re wonderful.
At the size we are, we earn operating earnings, $2.2 billion, or whatever it was in the first quarter, and we don’t pay it out, and our job is to put that out as intelligently as we can.
And we can’t find the See’s Candies that will sop up that kind of money. When we find them, we’ll buy them, but they will not sop up the kind of money we’ll generate.
And then the question is, can we put it to work intelligently, if not brilliantly? And so far, we think the answer to that is yes.
We think it makes sense to go into the capital-intensive businesses that we have. And incidentally, so far, it has made sense. I mean, it’s worked quite well. But it can’t work brilliantly.
The world is not set up so that you can reinvest tens of billions of dollars, and many, many tens over time, and get huge returns. It just doesn’t happen.
And we try to spell that out as carefully as we can so that the shareholders will understand our limitations.
Now, you could say, “Well, then aren’t you better off paying it out?”
We’re not better off paying it out as long as we can translate, as you mentioned, the discounted value of future cash generation. If we can translate it into a little something more than a dollar of present value, we’ll keep looking for ways to do that.
In our judgment, we did that with BNSF, but the scorecard will be written on that in 10 or 20 years.
We did it with MidAmerican Energy. We went into a business, very capital intensive, and so far, we’ve done very well, in terms of compounding equity.
But it can’t be a Coca-Cola, in terms of a basic business where you really don’t need very much capital, if any, hardly. And you can keep growing the business if you’re lucky, if you’ve got a growing business.
See’s is not a growing business. It’s a wonderful business, but it doesn’t translate itself around the world like something like Coca-Cola would.
So I would say you’ve got your finger right on the right point. I think you understand it as well as we do. I hope we don’t disappoint you, in terms of putting money out to work at decent returns, good returns.
But if anybody expects brilliant returns from this base in Berkshire, you know, we don’t know how to do it.
Charlie?
CHARLIE MUNGER: Well, I’m just as good at not knowing as you are. (Laughter)

Companies With The Best Return On Capital (2010)

BECKY QUICK: This question comes from Carson Mitchell in Aberdeen, South Dakota, who asks both of you, “What business has had the best return on capital for Berkshire, and what business of any on earth has had the best return on capital?”

And he adds, “PS, I would have come by rail but there are no seats in the grain rail cars.” (Laughter)

WARREN BUFFETT: There’s two ways of looking at it.
If you talk about the capital necessary to run the business, as opposed to what we might have paid for the business — I mean, if we buy a wonderful business — you could run the Coca-Cola Company —assuming you had the bottling systems — you could run it with no capital.
Now, if you buy it for $100 billion, you can look at that as your capital or you can look at the basic capital. When we look at what’s a good business, we’re defining it in terms of the capital actually needed in the business.
Whether it’s a good investment for us depends on how much we pay for that in the end.
There are a number of businesses that operate on negative capital. Carol’s with Fortune magazine. You know, any of the great magazines operate with negative capital.
I mean, the subscribers pay in advance, there are no fixed assets to speak of, and the receivables are not that much, the inventory is nothing.
So a magazine business — my guess is that People magazine operates, or Sports Illustrated operates, with negative capital, and particularly People makes a lot of money.
So there are certain businesses. Well, we had a company called Blue Chip Stamps where we got the float ahead of time, and operated with really substantial negative capital.
But there are a lot of great businesses that need very, very little capital. Apple doesn’t need that much capital, you know.
The best ones, of course, are the ones that can get very large while needing no capital.
See’s is a wonderful business, needs very little capital, but we can’t get people eating ten pounds of boxed chocolates every day.
CHARLIE MUNGER: Except here.
WARREN BUFFETT: We want to. (Laughs)
Generally, the great consumer businesses need relatively little capital. The businesses where people pay you in advance, you know, magazine subscriptions being a case, insurance being a case, you know, you’re using your customer’s capital.
And we like those kind of businesses, but of course, so does the rest of the world, so they can become very competitive in buying them.
We have a business, for example, that’s run wonderfully by Cathy Baron Tamraz, called Business Wire. Business Wire does not require a lot of capital. It has receivables and everything, but it is a service-type business and many of the service-type businesses and consumer-type businesses require little capital.
And when they get to be successful, you know, they can really be something.
Charlie?
CHARLIE MUNGER: I’ve got nothing to add, but at any rate, the formula never changes.
WARREN BUFFETT: If you could own one business in the world, what would it be, Charlie? (Laughter)
I hope we already own them, myself.
CHARLIE MUNGER: You and I got in trouble by addressing such a subject many decades ago.
WARREN BUFFETT: That’s right. (Laughs)
CHARLIE MUNGER: And I don’t think I’ll come back to it.
WARREN BUFFETT: OK. (Laughter) Number 13 —
CHARLIE MUNGER: If you name some business that has incredible pricing power, you’re talking about a business that’s a monopoly or a near monopoly.
WARREN BUFFETT: Sure.
CHARLIE MUNGER: And I don’t think it’s very smart for us to sit up here naming our most admired business or something, that other people regard as a monopoly.
WARREN BUFFETT: OK. We’ll move right along. (Laughter)

2011 Meeting: Earning Ability

My question is, aside from the need to put huge amounts of capital to work, do you still believe that a high return on tangible capital business, like See’s or Coke, is the best asset to hold in an inflationary environment, or do you now think an irreplaceable hard asset with pricing power, like a railroad or a hydroelectric dam, is superior?

WARREN BUFFETT: The first group is superior. I mean, if you can have a wonderful consumer product — doesn’t have to be a consumer product — a product that requires very little capital to grow, and to do more dollar volume, as will happen with inflation even if you don’t have unit growth, and it doesn’t take much capital to support that growth, that is a wonderful asset to have in inflation.
I mean, the ultimate test of that is your own earning ability. I mean, if you’re an outstanding doctor, lawyer, whatever it may be, teacher, the — you — as inflation goes along, your services will command more and more in dollar terms, and you don’t have to make any additional investment in yourself.
…..
The worst kind of businesses are the businesses with tons of receivables and inventories and all of that.
And in dollar terms, if their volume stays flat but the price level doubles, and they need to come up with double the amount of money to do that same volume of business, that can be a very bad asset.
Now normally, we are not enthused about businesses that require heavy capital investment, just like utilities and the railroad.
We think that, on the other hand, particularly with the railroad, that where you do not have any guaranteed lower rate of return, that you should be entitled to earn returns on assets that are becoming more and more valuable to the economy as — whether it’s because of inflationary factors or because of just natural growth factors, or in the case of the United States, I think it will be both.
But the ideal business — See’s Candy is doing — it was doing $25 million of volume when we bought it, and it sold 16 million pounds of candy — a little more than — well, it retails $1.90, and we had some quantity discounts, so we were doing close to $30 million worth of business.
Now, we’re doing well over $300 million worth of business. It took $9 million of tangible assets to run it when it was doing 30, and it takes about 40 million of tangible assets at 300-and-some.
So we’ve only had to ploy back $30 million into a business which will make us — well, it’s made us, probably, a billion-and-a-half pretax during that period.
And if the price of candy doubles, we don’t have any receivables to speak of. Our inventory turns fast. We don’t store it or anything like that. We gear up seasonally and the fixed assets aren’t big, so that is a much better business to own than a utility business if you’re going to have a lot of inflation.
Charlie?
CHARLIE MUNGER: And what’s interesting about it is that we didn’t always know this. And so — (Laughter)
WARREN BUFFETT: And sometimes we forget it. (Laughter)
CHARLIE MUNGER: That’s true, too.
But it shows how continuous learning is absolutely required to have any significant achievement at all in the world.
WARREN BUFFETT: Yeah, and it does show — you know, I’ve said in the past that I’m a better businessman because I’m an investor and I’m a better investor because I’m a businessman.
There’s nothing like actually experiencing the necessity, particularly in the 1970s when inflation was gathering strength, and early ’80s, you would see this absolutely required capital investment on a very big scale that really wasn’t producing anything commensurate in the way of earnings.
I wrote an article for Fortune called “How Inflation Swindles the Equity Investor” back in 1977.
You really want — the ideal asset, you know, is a royalty on somebody else’s sales during inflation, where all you do is get a royalty check every month, and it’s based on their sales volume.
And you made — you came up with some product originally, licensed it to them, and you never have another bit of capital investment. You have no receivables, you have no inventory, and you have no fixed assets.
That kind of business is real inflation protection, assuming the product maintains its viability.
So even though we are going into some very capital-intensive businesses, part of that reflects the fact we can’t deploy the amount of capital we have in a whole bunch of See’s Candies. We just can’t find them. We would love to find them, but we can’t find them in that quantity.
So we are not doing as well with capital when we have to invest many billions a year, as we would if we were investing a few millions a year. There’s no question.
That’s true in investments. It’s true in operating businesses. There is a real disadvantage to size, and we just hope that problem grows.

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