Great Businesses According to Buffett

I finished digesting the latest Berkshire Hathaway 2007 letter to shareholders today. I found the most interesting part of this year’s letter was Warren Buffett’s discussion of what kinds of businesses turn him on.

The companies that he and Charlie Munger look for are:

  1. Understandable
  2. Businesses with favorable long-term economics
  3. Run by trustworthy management
  4. Selling at sensible prices

Mr. Buffett once again reiterates that “a truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” Fat Pitch Financials has been all about finding companies with wide moats ever since I first set up this blog in 2004. Given my economics background, I find Buffett’s arguement for the need for wide moats compelling. He argues that companies that lack a barrier to competition will succumb to the competitive forces of a capitalist market that tend to drive profits to zero. In this year’s letter, Buffett provides the example of GEICO’s and Costco’s low-cost production and Coca-Cola’s (KO) and Gillette’s world-wide brand as formidable barriers that are essential for maintaining enduring competitive advantages. Other durable competitive advantages include legal protections, high switching costs, the network effect and toll bridges. I discussed these barriers to entry in my review of Ten Ways to Build Moats to Hold Back Competition. The key is that these moats need to be “enduring” in order to avoid the creative destruction of capitalism. Companies in industries prone to rapid and continuous change are to be avoided, since it is unlikely their moats will be enduring.

In the past, Mr. Buffett often talked about return on equity, but many had assumed he actually meant returns on invested capital. This assumption was right since in this letter Mr. Buffett explicitly mentions returns on invested capital (ROIC). I think this is the first letter Warren Buffett has been so explicit about the importance on returns on invested capital. He actually also notes the importance of looking at a business’s returns on incremental capital invested when he discusses See’s Candy. Shai Dardasti examined Warren Buffett’s discussion regarding See’s Candy in a recent blog post that I highly recommend.

While Buffett says it is important to have trustworthy management, he also notes that if you restrict your investments to companies with durable competitive advantages that this “eliminates the business[es] whose success depends on having a great manager.” Invest in companies that can be run by an idiot because often one eventually will. Buffett reminds us in his letter that a great business should not require a superstar to produce great results. Buffett uses the example of a successfully growing medical practice led by a premier surgeon, but unlikely to be as successful if this leading surgeon leaves. However, the well know Mayo Clinic is likely to endure regardless of who is running it. This reminder makes me a bit nervous about my investment in Western Sizzlin (WEST), because I think Sardar Biglari is likely critical for that company to produce great returns. Of course, for many years it could be said that Warren Buffett was required to produce great results at Berkshire Hathaway (BRK-A).

Finally, Buffett also notes how advantagous it can be to have a business with low capital investment requirements. I can personally attest to that advantage. My online business has virtually no capital requirements, but has the ability continually increase its earnings.

Great businesses have sustainable competitive advantages, low capital investment requirements, don’t require superstar managers, and are in stable industries. Do you have any companies that fit these criteria? Share them below to see if they can hold up to Buffett’s criteria for great businesses.

6 thoughts on “Great Businesses According to Buffett

  • March 6, 2008 at 6:58 am

    IMHO Freddie Mac fits the bill. Unscalable Barriers to entry, high ROE, economy of scale, captive customers. They have the ability to borrow at lower cost than their competitors and match the time of their borrowing to the time of their loan.
    Temporary market conditions have priced this company right.

    Another company is Labcorp. They function in a duopoly. They have economies of scale.

  • March 6, 2008 at 10:42 am

    Picked for post of the day at _________ matters.

  • March 6, 2008 at 10:58 am

    Thanks Nick! I’m honored that it made your post of the day.

    alex – How does Freddie Mac have captive customers? I hate Labcorp as a customer, but maybe they are a low cost producer. I’ll have to check them out more closely.

    Another duopoly worthy of being called a great business is Sotheby’s (BID). The only real competition for them is Christie’s.

    To encourage more ideas, I’ll try to post a new great business here for every ideas submitted. Keep them coming…

  • March 8, 2008 at 10:20 am

    Excellent read! Thanks for sharing it. I plan to include your article in my weekly carnival/article review Friday.

    Best Wishes,

  • October 9, 2008 at 10:53 pm

    It is interesting to see someone’s take on Freddie Mac just 6 months ago. Who would have thought…

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