Buy Right Sit Tight - 2018

Businesses - The Great, the Good, and the Gruesome!

By Amit Rupani

Warren Buffett in his 2007 annual letter explained difference between a great, good, and gruesome business. Let us dive into each of these types of businesses to better understand them.

The Great: A great business is one which generates high return on invested capital and doesn't need much extra capital to grow its earnings. Warren shared See's Candy as an example for great business. Warren Buffett bought See's Candy business in 1972 when it was generating around $5 million pre-tax earnings. The capital then required to conduct the business was $8 million. It was earning ~60% pre-tax on invested capital. In 2007, See's was generating pre-tax earnings of $82 million and the capital then required to run the business was $40 million. Its pre-tax return on invested capital went up to ~200 percent from 60 percent. Between 1972 and 2007, See's generated total $1.35 billion in pre-tax earnings for Berkshire and Warren used these annual cash flows (after paying taxes) to buy more attractive businesses. Warren mentioned in his letter that just like Adam and Eve kick-started an activity that led to billions of humans, See's gave birth to multiple new streams of cash for Berkshire Hathaway.

Great businesses essentially are the ones whose business economics have low capital requirements to grow the earnings. They are like getting more and more sugarcane juice without putting in the new sugarcanes. There are very few “great" businesses on this planet but few like Google, Microsoft, American Express, Unilever, Gillette, and Nestle would qualify in this bucket. Great businesses, earnings huge returns on capital, can't for any extended period reinvest a large portion of their earnings internally at high rates of return.

The Good: A good business is the one which requires significant reinvestment of earnings for it to grow further. Warren shared example of his FlightSafety business which was bought in 1996. FlightSafety provides model simulated airplanes for training pilots and crew members. In 1996, its pre-tax earnings were $111 million which was generated by deploying $570 million of capital, providing ~20 percent return on invested capital. Between 1996 and 2007, FlightSafety had to invest total $1.635 of additional capital for simulators to match new airplane models that are constantly being introduced. Pre-tax earnings in 2007 were $270 million, a gain of $159 since 1996. As we can see, FlightSafety is a good business but far away from See's where additional $509 million dollars were invested in the business to maintain its competitive position in the market.

Most of the businesses on this planet are like FlightSafety where additional reinvestment of earnings is needed to grow the earnings. Most banking businesses qualify in “good business" bucket. Assume you have a bank which earns 20 percent return on invested capital. So you invest $100 at beginning of the year and the earnings you get end of the year is $20. Now if you want to double your earnings from $20 to $40, you will have to add additional $100 in the business. This is what a typical good capital intensive businesses like banks work.

The Gruesome: A gruesome business is the worst sort of business that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. According to Warren, airlines are a type of gruesome business. The airline industry demands additional capital for reinvestment in its growth but at the same time earns very little return on capital on the invested capital. There are few exceptions in the airline industry that have generated decent return on invested capital, but they have been very few. But the crux here is that any business which generates low return on invested capital and then requires additional capital to grow which also earns low return on capital would qualify under “gruesome" bucket.

To sum up, think of three types of “savings accounts." The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Happy investing!

Note: The above examples of “Businesses – The Great, the Good, and the Gruesome!" are adapted from Warren Buffett's 2007 annual letter for Berkshire Hathaway shareholders. Stocks discussed above are for example purpose and not Buy or Sell recommendation. Please consult your investment advisor before acting on any of the above discussed stocks.

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com