Author: Ben Tewey

Date: 3/14/21

The Early Stages

When I first began investing and buying businesses I was a dog chasing cars: I had no idea what to do when I caught one. Knowing what to look for and what characteristics attractive businesses had was difficult. Often, like the dog, I chased the fastest, most flashy ones despite not knowing what I was getting myself into. I’ll admit I bought into two SPACs and high multiple software companies with little to moat, or earnings that fulfilled none of the categories I am about to lay out. However, before this article turns out to be a revival meeting where I confess all of my sins, let’s talk about what I have learned. 

Oh How I’ve Learned

So far, in my limited time investing (coming up on the 1 year anniversary) I have followed three men very closely: Warren Buffett, Charlie Munger, and Bill Ackman. Naturally, therefore, I follow much the same style they do and look for businesses in the same manner. 

First the Buffett/Munger school of thought:

“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety.  We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.  We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.  In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”

Great, that’s 4 criteria that seem easy enough to follow. Just look for easy business models that will succeed in the future with excellent management and make sure to not pay too much for them.

Bill Ackman’s influence may be more evident for the consistent readers of this website in that it outlines the way we write our articles at VestRule. Following Ackman’s school of thought we generally look for (1) simple & predictable, (2) cash flow generative, (3) dominant business with a (4) high barrier to entry, that (5) earn high returns on capital that are (6) limited exposure to extrinsic risk management cannot control, have a (7) strong balance sheet and (8) excellent corporate governance/management.

Simple & Predictable

At least 70% businesses fail to pass this filter for me. The business the investor is looking into should fall in his or her sphere of competence, in other words the business should be easy to understand. When we say “understand”, think of Kanye talking about Lady Gaga being the creative director at Polaroid. She can sing well, but what does she know about cameras? Understanding a business does not mean knowing how they generate revenue comes from. Of course that is the most basic thing to understand, but instead know competitors, industry trends, new innovation that may disrupt the industry, how interest rates affect the company, what defines a strong moat etc. 

Cash Flow Generative

The purpose of a business is to make the owner money, being a stockholder you are the owner. If the business operates at a loss or worse yet the cash flow operations consistently negative you cannot reasonably expect that investment to pay you cash in the future. And isn’t that the point of investing, laying out cash now in hopes of getting more in the future?

Dominant Businesses

For long term investment you want securities in business that dominate their industry, you want leaders– investing in turnaround stories rarely works and at the very least is unnecessarily stressful. 

High Barrier to Entry 

Investable businesses have a distinct competitive advantage, Buffett’s famous moat. A business needs to be able to retain its position in the corporate arena. Moats can be anything from an economy of scale, an enthralling ecosystem, better technology, buying power, brand identity, and/or patents.

Earn High Returns on Capital 

The more capital invested in a business, ideally, the more money should come out. As Warren Buffett articulated, “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” There are three categories, but ideally the investor should constrain his or herself to ones that produce high returns on capital with low capital requirements. Think Visa, Facebook, or See’s Candy. For more on the other two categories read this article. 

Limited Exposure to Extrinsic Risk

It is advantageous that a business is not affected by risks out of its management’s control i.e political risk like government regulation, economic downturn, natural risks such as earthquakes.

Strong Balance Sheet 

Penultimately, investable businesses are securely financed with a strong balance sheet and are in no danger of going bankrupt, have little to no debt or if they do they have plenty of cash and cash equivalents to make up for it, and have a healthy ratio of tangible assets to total liabilities. 

Excellent Management 

Once we have found our castle with a deep, wide moat we would like to have a king sit atop the throne and rule over the castle. We want fantastic management that earns high returns on tangible assets and equity, that has integrity and loves to come to work because they are passionate about what they do. 

Final Note

Even if a business fulfills these criteria, the intelligent investor still must pay a reasonable price for said business. No business can continuously grow at 15% terminally as this would imply that one day the business would be larger than the world economy. Axiomatically, there is a limit to how much one can reasonably pay for a business. It is important to remember that when you buy stock in a company you are becoming a part owner of said business. 

Bibliography

Warren E. Buffett Berkshire Hathaway Letter to Shareholders 1992.

Warren E. Buffett, Berkshire Hathaway Letter to Shareholders 1977.

Buffett’s 3 Categories of the Return on Invested Capital Formula.  

Disclaimer 

I am not a financial advisor. These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments. Please consult your financial or tax professional prior to making an investment.