Attributes of a Great Business and a Simple Investment Checklist
A follow up on the Nebraska farmer's great investment and some takeaways: Two attributes that each great business needs, some examples of what matters in the long run, and Saber's simple checklist
In the previous post, I told the story of how a Nebraska farmer bought shares in the 1960's and never sold them. A similar success story: my dad once worked with someone who bought McDonald's stock in 1965 shortly after the IPO. He bought 100 shares of MCD because he liked the food, he was impressed by how cheaply he could feed his family for a dinner out, and he thought other customers would soon recognize this value as well. In short, the business had a great product that was likely to grow for a long time. What's interesting is these 100 shares were purchased for around $40 (a $4,000 total investment), which meant the stock had nearly doubled from its IPO price earlier that year. Those 100 shares (after 13 stock splits and a 2% stock dividend) are now 74,358 shares. The $4,000 investment is now worth nearly $22 million (this investor wanted to sell the shares years ago, and his wife didn't want to sell: they compromised by selling half, a decision he said he regrets! — but half of those original shares remain in his coffee can).
I referenced this story here because there seems to be some interesting similarities between the Nebraska farmer and the McDonald's investor.
Thanks for reading Base Hit Investing! Subscribe for free to receive new posts.
Many will immediately discard stories like this and claim “survivorship bias”. There is some truth to this of course, but it's more practical in my view to see if we can draw some lessons from these fun stories that might be useful to our own investment process.
I thought of three general takeaways:
The first is simplicity. Both investors had a very simple but valuable insight: Buffett is smart and is going to do well for a long time; McDonalds food is good and is cheaper and faster than any other option and there are lots of customers who will love this.
They probably felt that their insight was valuable and would lead to a lot of growth, so they bought the stock, put it in the coffee can and owned it as if it was a private stake in a family owned company.
Simple but powerful insights can be valuable and also long-lasting (if an investor has the right temperament).
The second is to ”Zoom Out”. The simple insight they had wasn't going to change over the course of a quarter, a year, or even a business cycle.
This probably helped the investors avoid selling these stocks when they fell 50% or more during the 1970's or when the fundamentals looked especially challenged in the early 80's (see my comments in last post on Buffett's 1980-82 letters; the insurance business didn't look pretty then). These investors may not have even paid much attention to those fundamentals. They were able to zoom out and remember the main core advantage that truly mattered.
This is a big takeaway from this story. For those of us who do practice investing as a career, we do pay attention to the little details. We do read the 10-Q's each quarter. And while this is a necessary part of the job to fully understand the companies we own, it's important to remember that the best investments and the best businesses tend to have just a few things (sometimes less than a few) that really matter.
It's a good reminder to have a big picture thesis. See "Sources of Enduring Business Success" that discusses this in more detail.
Most importantly, both companies had a business advantage that perpetuated itself (it got stronger as it grew):
Berkshire's biggest advantage was the capital allocator at the helm and the reputation and trust that he accrued over time, which gave Berkshire some impossible to replicate advantages (the balance sheet plus the reputation allowed it to get great terms in crises, write insurance that no one else could write, and buy certain companies whose owners prioritized culture; these advantages grew as Berkshire grew)
McDonald's advantage came from a business system that emphasized consistency in both operations and products, which made it easier to successfully replicate the model across the country via franchises, all while building real estate value for the parent company (and future operating leverage) with each new location
I keep a list of businesses that pass what I think of as the “10-year test”: those with some kind of meaningful and understandable business advantage that makes me highly confident that earnings will be higher a decade from now.
What makes a great business persist for many years?
One question I posed to some friends in Omaha: what attributes lead to these “perpetual business advantages” — what are those traits that tend to last and sometimes even strengthen as the business grows?
Apple's brand value will persists beyond iPhone upgrade cycles
NVR's culture and incentive structure won't change in a housing downturn
Floor and Decor's low cost and product selection advantage will outlast any consumer spending slowdown
Copart's auction has the most cars which attracts the most buyers which further adds to the value insurance companies get from the platform and this won't change if used car prices or miles driven trend up or down in any given year.
Amazon's monstrous scale advantage in logistics that allow it to ship packages cheaper and faster than anyone else will trump any mistakes caused by adding too much capacity too quickly
Sometimes what matters is a strategically located (and impossible to re-create) asset that produces high margin royalties like mineral rights near the Gulf of Mexico
Some of these things can change over time, but the point here is to keep focused on what really matters to the ultimate success of the business.
They are long lasting and slow to change. They are part of the fabric of the business. Of course, even these long duration advantages can decline if they are not fostered properly, but the point here is to keep focused on what really matters to the ultimate success of the business. The Nebraska farmer just had to stay focused on whether Buffett's principles were intact: honesty, rational behavior, long-term mindset and a focus on value. These were what (I presume) led the Nebraska farmer to buy into Berkshire, and it is probably what kept him in the stock for 5 decades and counting.
3 “Must-Haves” For a Great Long-term Stock
A friend and I shared a box of peanut brittle in the lobby of his hotel the afternoon of the meeting and we were talking about how a great multi-decade long-term investment really tends to require three main things:
The first is what I described above: some kind of advantage that “perpetuates” itself over time
The second is great capital allocation
Low enough starting valuation
My friend Connor Leonard pointed out a Buffett quote that said it best:
“After 10 years on the job, a CEO who company annually retained earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”
Buffett is using the example of a company that earns 10% ROE. The same math on a 20% ROE company that retains its earnings means the CEO will have deployed 82% of the company's entire capital base in just 10 years. Five years after that and this number rises to 93%, nearly all the capital in the business.
The upshot: the longer your time horizon, the more that capital allocation matters to the value of your stock.
One way to judge the effectiveness of capital allocation is to measure the return on incremental capital (I wrote a series on the importance of this back in 2014-2016 and I'll touch on this again in some upcoming posts).
I divide companies into two groups:
Phase 1 are the reinvestment engines that retain capital — they soak up capital because they have attractive places to reinvest (e.g. Floor and Decor earns 30% cash on cash returns on each $10 million that they lay out to build a new location; as long as they can earn these returns they should reinvest every dollar of earnings).
Phase 2 are the companies that have no more room to reinvest. The company FND is modeled in part after is Home Depot, which for the most part hasn't opened new stores in over a decade but still has compounded value per share at roughly 15% per year through a combination of more customers (more transactions), pricing increases, efficiency improvements (higher operating margins) and buybacks. Said another way: each HD store sold more units at steadily higher prices, which increased the cash flow per store while decreasing shares outstanding per store. Each of those four categories have contributed roughly 3-4% annually, which together has led to a mid-teens return with very little incremental capital invested.
Both Phase 1 and Phase 2 companies can compound value and be great investments at a certain price if the management has effectively allocated capital.
Regardless of the stage of a company’s lifecycle, I’m looking for the following items in this general checklist in each of my core investments:
Simple: Do I have confidence in what the business will likely look like a decade from now? (what I call the “10-year test”)
Consistent FCF and ROE
Higher earnings: Am I confident the business will have higher earnings a decade from now? (To pass this test, a business usually needs one of the perpetuating advantages discussed above)
Great Capital allocation: Do I understand it? Can I measure it? What are the returns on incremental capital? Will this stock have fewer shares in a decade? -
Geoff Gannon at Focused Compounding recently framed this ROIC topic nicely. What we're really trying to figure out is: how much can the business grow and how much capital will need to be retained to fund this growth? As Buffett says, the best businesses are the ones that can grow without needing capital (which actually is a combination of Phase 1 and Phase 2); but the value can compound in both phases of a company's life depending on valuation levels and capital allocation decisions.
Value: How certain am I to earn at least 12% returns over time in this investment? What is the rate of return we can expect (I use the three engines of growth, capital returns, and P/E multiple change to help me estimate this number)
Saber's watchlist contains a page of companies that show evidence of both perpetuating business advantages and high-quality capital allocation. The result of these two attributes should hopefully result in a business that is likely to have higher earnings and fewer shares in a decade. My job is to then wait for the stock to reach a price where my rate of return meets my objectives.
The Berkshire meeting and the Nebraska farmer/McDonald's investor case study are great reminders of the success that can come from investing in companies that possess both of these two simple characteristics.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at email@example.com.
Thanks for reading Base Hit Investing! Subscribe for free to receive new posts and support my work.