What is the best business according to Warren Buffett? A business that has the highest rate of return on tangible capital over time. This requires characteristics that will be discussed in this article. Finding such a business can greatly increase your investment returns over time.
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The best business has high returns on tangible capital
Warren Buffett has mentioned what he considers to be the best business in many letters. For example in the recent letter to shareholders of 2019 where he discusses his selection criteria:
In addition, we constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.Warren Buffett, 2019
What is return on tangible capital?
Net tangible capital means that Buffett looks at the investments that a company must make to operate. A company needs inventory, accounts receivable and fixed assets to produce its goods/services. The goodwill is an intangible asset that can include the brand name used to create a franchise for which customers are willing to pay (e.g. the brand Coca-Cola).
Goodwill is ignored by Warren Buffett when he looks at great businesses. The tangible assets must be replaced over time and this means that the company has to spend money. The goodwill does not need to be replaced. The more economic goodwill (goodwill that leads to above average returns) the better.
As this means that the company requires less capital to operate (less spending, more cash for shareholders). Hence, the return on net tangible capital (free cash flow divided by tangible capital).
Warren Buffett on capital requirements
Buffett names Microsoft and Google in 2007 as examples of companies who don’t need to raise additional capital to finance the business. These businesses generate enough cash to finance capital assets (plant, property and equipment) and costs and expenses. Note that accountants use costs for the direct costs for making the products (costs of goods sold) and expenses for the operational expenses (Sales, General and Administrative expense). Too many fast growing companies need to fund the growth with new capital (debt and equity). Basically meaning that no money is available for the shareholders.
It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.Warren Buffett, 2007
Generating high returns on capital leads to lots of cash that will keep on snowballing over the years.
Google and Facebook – free cash flow and capital expenditures
Note that Google for instance does make large capital expenditures (capex) for their data centers in 2020. But a lot of this capex is for growth and not only maintenance of the servers. The 2019 annual report of Google (Alphabet) shows the following about capex:
Our capital expenditures have grown over the last several years. We expect this trend to continue in the long term as we invest heavily in land and buildings for data centers and offices, and information technology infrastructure, which includes servers and network equipment.Alphabet – Annual Report 2019
Google has an operating cash flow of $54.5 billion and capital expenditures of $23.5 billion for 2019.
Let’s compare Facebook and Google
Facebook (a close competitor) has capex of $15.65 billion and an operational cash flow of $36,31 billion (Annual Report 2019). Capex will even be $17-19 billion next year according to Facebook’s latest annual report. Both Google and Facebook need to spend a lot on capex to stay on top of their game. Fortunately, the operational cash flow is also growing which leads to satisfying free cash flow results for investors.
Microsoft – an example of an outstanding business
The capex expenditures for Microsoft are still relatively small compared to the operating cash flow. So, Microsoft can produce a lot of free cash flow. At the end of the article we find one of the reasons for the relative low capex of Microsoft.
The stock price of Microsoft has risen along with the cash flow increases.
A simple check for spotting high returns on capital
In 1992, Warren Buffett mentions what the best business is by using slightly different words:
Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of returnWarren Buffett, 1992
The key here is incremental. Simply put, can the business reinvest all the earnings or do they pay them out? A high return on equity can be maintained more easily by a business if it had good returns in the past, and then pays out the future earnings. The returns in such a case come from the old investments, not from the new investments. So, the investor wil learn dividends but not the large stock appreciation.
You will find this by looking how much capital (long term debt and equity (e.g. retained earnings)) the company adds over let’s say 10 years. Then you can compare this to the additional free cash flow that the business generated in the same period. This can give a good indication of how effective the business was in allocating capital to generate earnings.
By looking at the last 5 or 10 years, you incorporate only the incremental capital and not the capital that was already invested in the business. This will allow the investor to see if the high returns are produced with new investments. Often, mature companies return much of their earnings to shareholders instead of reinvesting it. This leads to lower incremental (additional) returns on capital.
Retaining earnings makes sense if a business can reinvest
A business that can invest in high return investments can best serve its shareholders by retaining its capital. This will add much more value to the stock than simply paying the capital out in dividends. A restaurant chain with high same store sales (the additional sales of a new store) can best use the capital to open more stores. As long as the additional return is satisfying.
The 1 dollar market rule of Warren Buffett can also be checked by see how the market value changed over 10 years and how much capital was retained. 1 dollar retained should generate at least one dollar of additional market value over the years.
Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of returnWarren Buffett, 2007
The worst business is a company that grows fast and uses a lot of capital without earning much additional cash! Warren Buffett names airlines as an example in 2007. Note that Buffett currently owns airlines, likely due to the low purchasing price compared to the earnings. A low price for compared to (stable) earnings can still be a good buy. Buffett is likely focusing in this case on the margins and airline passengers per airline company.
Explaining the characteristics of the best business
The book Money Masters by John Train lists besides the investor behavior also the characteristics of the best business. Let’s go briefly over some of these best business qualities and see what Buffett means.
- Good return on capital without much debt (debt can leverage the returns but increases risk
- Understandable (you must know how the business earns its money)
- They see their profits in cash (see owner’s earnings or free cash flow)
- Strong franchises and freedom to price (competitive advantage/moat and the ability to raise prices above the market average and inflation)
- They don’t take a genius to run (Coca-Cola’s success doesn’t depend on one typical CEO)
- Predictable earnings (otherwise you can’t predict the future cash flows)
- Low inventory and high turnover of the assets (meaning that less money is invested in the business and higher returns on capital because you sell your inventory fast)
- Management cares about the business owners (the stock holders)
- The best business has a royalty on the growth of others
Growing on the investments of others
“Having a royalty on the growth of others” is best understood by thinking of a company that can use the expenditures of another company in its advantage. Microsoft is a good example. Companies like AT&T pay for the internet and network. IBM makes the computers. These things require a lot of capital that has to be invested and that is stuck in inventory and accounts receivables. Microsoft used this to its advantage by supplying computers with software (Windows and Office).
The marginal costs (costs of one additional service/product) for Microsoft are almost zero to supply an additional computer with software. They could simply grow along with the investments of other companies. Facebook is another example. The users are creating the content and Facebook has a huge gross margin due to its low costs of goods sold (it has no inventory).
Only a few business qualify as ‘best business’, but when you find such a stock, you don’t have to worry about falling market prices and recessions.
Conclusion The best business can lead to very satisfying investment results
Finding the best business requires a very good understanding of the investing characteristics and principles. This will ensure the investor that the business is good and will remain able to produce a lot of cash for the shareholders. Confidence and compounding knowledge will help to allocate a respectable amount of wealth to such an investing idea. Over time, the compounding will do the magic of increasing your wealth.
Again a fair warning must be given that this requires discipline, skill and a good understanding of the risks. For instance, overpaying can deteriorate the returns significantly. Index funds will serve the needs of most investors by offering a satisfying return over the long run without the need to perform research.
Please see my long term stock picking page for more information about long-term investing.
18 thoughts on “The Best Business According to Warren Buffett”
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