Investing From a Business Perspective

“Investment is most intelligent when it is most businesslike.”  This is the key idea Warren holds when investing. It means that one stops thinking of the stock market as an end unto itself and begins thinking about the economics of ownership of those businesses that the common stock represents. Warren’s chief idea is to buy excellent businesses at a price that makes business sense. Thus, listening to your stockbroker say that he thinks XYZ stock is a timely buy and that in the last week it has moved up three points, is a total folly. Your stockbroker is only trying to entrap you in the enthusiasm of the horse race of numbers found every morning in the Wall Street Journal. So what makes business sense? Warren thinks it is to invest in businesses with the highest predictable annual compounding rate of return with the least amount of risk. Warren does this better then anyone because he knows that the ownership of the powers of production of the right business is of greater value over the long term then the short term profits usually promoted by Wall Street professionals.

In order to understand Warren’s view of investing from the business perspective, one must first understand his unorthodox view of corporate earnings. Warren considers, for example that if a company earns $5 a share and that if he owns one hundred shares of the company, he has just earned $500 ($5 x 100 =$500). He also believes that the company has the choice of either paying the $500 out to him via a dividend, or retaining those earnings and reinvesting them for him, thus increasing the underlying value of the company. Warren believes that the stock market will see this increase in the underlying value of the company, causing the stock’s price to rise. This view differs from most Wall Street professionals, as they don’t consider earnings theirs until the earnings are paid out in the form of dividends. To Warren, this is plain stupidity as he thinks earning should be retained if the company can profitably employ them at a rate of return that is better than the investor could. Warren also believes that since dividends are taxed as personal income, there is a tax incentive in letting the corporation retain all its earnings. Furthermore, dividend payment would put the earnings in the hands of the investor, which would burden him with the problem of reallocating the capital to new investments.

The rate of return is the actual figure you will be making as an earning from your investment (a number Warren likes to pay close attention to). Warren also pays close attention to the price you pay for a stock, as it is one major factor that will determine your rate of return. In order to calculate the rate of return, another number needed is the yearly per share earning. This is a figure you will not know at the time of purchase, but a figure you will have to predict, or guess. For the obvious reason, Warren likes to invest in companies with reasonably predictable earnings.

To wrap this up, the three variables you will constantly be addressing when using Warren’s system of analysis are:

1. The annual per share earnings figure

2. Its predictability

3. The market price of the security.

Following the three variables system, you will only have to answer two questions when trying to make an investment: What to buy (companies with predictable earnings per share), and at what price?       

This seems simple enough, but there are many Wall Street professionals who go against this analysis. The problem is that many Wall Street investment bankers and brokers function basically as salesmen working for a commission.  For obvious reasons, they want to get the highest price possible for the goods they are selling.  Thus the buyer will most likely not get a bargain.  New issues are priced at the maximum to allow issuing companies to get the most money for its shares and the investment banks to receive the highest commissions.  The stockbrokers on the phone are only interested in selling the priciest item that they can. When a stockbroker is selling you a new issue, you should know immediately that the stock has been fully priced by the investment bank and that you are not getting a bargain.  If a stockbroker is trying to sell you a stock on the prospects of the stock price rising, you must see through that he does not care about what price he sells it to you at all, which is as dumb as you can get in this game.  There is never a stockbroker who will call and say, “ XYZ is an excellent company but its price is too high.”

Understanding this common folly stock brokers and investment bankers try to push us into, when Warren picks and buys stocks, it is as though he goes to a store and determines what he wants to buy, then waits for it to go on sale.  Thus when buying a security, he already knows what companies he would like to own.  All he is waiting for is the right price. For Warren, the “what to buy” question is separate from the “at what price” question. He answers the “what to buy” question first, and then determines if it is the right selling price.

Compounding Rate Of Return

Before going on any further, it is important to explain how the magic of compounding sum of money fits into Warren’s investment philosophy, as his real trick in investing is to get a high annual compounding rate of return.

As you may know, compounding works in a way that if you invested $100,000 in the following way, your return would look like the following.

As seen, the huge difference in returns with just a few percentage point differences over a long period of time is simply amazing. Here is a quick example using compounding.

Let’s say a bond investor puts in $1,000 to General Motors for 5 years at a fixed rate of 8%. The investor receives $80 for five years and at the end of five years will get $1,000 back from GM. The investor would have received $400 in interest. From a tax standpoint, every time the investor receives his $80 from GM, the IRS will consider this as an income tax, lets say around 31%, which means the investor’s after tax yearly return will be $55.20. So after tax, the investor would earn $276 in interest for the five-year period. But this would completely change, if GM, instead of paying out the 8% to the investor and subjecting it to personal income taxes, automatically added it to the principle amount the investor originally loaned the company. In this case, the interest earned will look like the following.

The investor then would be taxed 31%, making his after tax earning into $323.83, which sounds great. However, the IRS also knows about this great trick and will not let you get away with this. But for Warren the IRS missed one very important point, that when buying company equity, (which to Warren is like an bond, only without fixed payments) returns will not be subject to personal income tax unless it is paid out as a dividend to the investor. Going back to the subject of companies retaining earnings, Warren is protected from personal taxes as long as the company does not pay its earnings out as dividends. The earnings that are retained by the company will compound at the effective rate of return, which the company can profitably reinvest.

A little follow up on how serious Warren takes the power of compounding:  Warren is famous for driving older-model cars. In the early days he drove a VW Beetle. If the automobile cost $20,000 today, to the normal people it would be worth almost nothing in ten years. But to Warren, who thinks he can get, say, a 23% annual compounding return on investment, means that the $20,000 invested today will be worth $1,256,412 in ten years, and in thirty years, $9,958,257. To Warren, $9,958,257 is just way too much money to throw away on a new car.

Types of Businesses to Invest In

Taking all this in to account, we will start looking at the kinds of business Warren likes to invest in.  Warren thinks that knowing the kind of business to invest in is the most important aspect of investing. He thinks it is even more important than the price to buy it at. Warren always followed his mentor Graham’s philosophies but later on he adopted the philosophies of Philip Fisher and Charles Munger of investing in companies. Their philosophies were to invest in businesses that have superior economics working in their favor and are selling for the right price. Warren began to follow this. Graham on the other hand thought that all businesses were possible candidates for investments as long as they were selling at a bargain price. Warren saw the problem with Graham’s theory of the realization of value problem. Warren said that if Graham believed the share was worth $62.50 but was selling at $50 then the stock was undervalued by $12.50. If Graham invested in the company at $50 and the stock rose to $62.50 then he would make 25% return on his investment on the first year. But if it dropped then he would lose money. Thus if it keeps dropping, then he loses money and has no returns. This is the realization of the value problem that Warren saw and decided to adopt the principles of Philip Fisher and Charles Munger. Warren felt that the methods of Graham lacked uncertainty and he held holdings that never performed. Some examples of his downward trends based on Graham’s philosophies were Vornado, Sperry & Hutchinson, and Dempster Mill Manufacturing. In some cases however Graham’s theories worked and it gave positive returns but taxes would erode his profit.

Warren began to follow Fisher and Munger’s theories, which was to invest in companies with good economics of business. They said that even though a company sold continuously below its intrinsic value, if the profitability of the company kept improving, eventually the price of the stock would rise to reflect the improved economics of the business. Warren was a true believer of this. A good example of this was when Warren started buying the stock of General Foods, the EPS started increasing as the earnings rose, and the intrinsic value of the company rose as well. With this the stock price rose as well. Under Graham’s theory, Warren might have sold the stock as soon as it started seeing an increase in earnings and then the stock price. But he did not because he considered General Foods is the kind of business that has an expanding value. Even though at times the stock was selling below its intrinsic value, the market price continued to rise. Warren was confident that the market price would rise eventually because the economics of the business would allow the company to experience long-term economic growth, which would be seen in the increasing per share earnings. Warren earned a return of at least 13% and often near 20%.

Warren found that mediocre businesses didn’t have predictable earnings. Even though in the short term the company may have periods of hopeful results, the competitiveness in the business world would rule out any profitability. He found that even though the market did close the gap between market price and the projected intrinsic value, his returns were dull because the gain was limited to the difference between the spread of the intrinsic value and the market price and capital gains tax would also eat his returns. Thus Warren always bought an excellent business with expanding value as opposed to a mediocre business with static value. With an excellent business Warren could hold his investment indefinitely, rather than to get out of it early. By holding it, Warren avoided the capital gains tax to some far of date and enjoyed compounding retained earnings. Here are some examples of his investing in excellent businesses.

The Washington Post is a good example of this. Warren bought 1,727,765 shares in 1973 for $9,731,000 and still has it with him. Today it is worth $600 million, giving him a compounding return of about 18.7%. GEICO is another example of this. He bought $45,713,000 worth of shares in 1972. In 1995, it was worth $1,759,594,000 giving him a compounding rate of 17.2%.

Warren regarded mediocre businesses as commodity type business that produced inferior results with price being the most important motivating factor in the consumer’s buying decision. Some examples are textile manufacturers, steel producers, gas and oil companies, and paper manufacturers. A good example is Company A making improvements in its manufacturing process, which lowers it’s cost of production, which increases its profit margins. Company A then lowers its price of product to gain market share. Companies B, C, D start to lose business and they also do the same thing that Company A did. Thus destroying any profits made by company A. Warren regards commodity type businesses offer the least for future growth of shareholder value. Profits are low because prices are kept low so the money is not there to expand and even if they did make money then the money is spent in upgrading plant and equipment. Identifying a commodity type business is not hard. Warrant regards these characteristics – low profit margins, low returns on equity, difficulty with brand name loyalty, presence of multiple producers, and erratic profits.

The 8 Key Questions In Determining a Consumer Monopoly

Warren regards the excellent business a consumer monopoly. He would invest his money only in this. Warren has 8 key questions that he asks to determine if it is a consumer monopoly, exceptional business economics, and shareholder-oriented management.

1) Does the business have an identifiable consumer monopoly?

By this Warren means that if you go to some convenience store or supermarket and if they carry a brand name, then the chances are that it is a consumer monopoly. Some examples are USA Today, Coca-Cola, and Marlboro cigarettes.

2) Are the earnings of the company strong and showing an upward trend?

Warren is looking for annual per share earnings that are strong and show an upward trend.

3) Is the company conservatively financed?

Warren likes companies that are conservatively financed. He thinks that if a company has a consumer monopoly then it is spinning off tons of cash and is no need of a long-term debt burden. Some examples are Wrigley and UST. In some cases Warren says that if long-term debt is used by a company to acquire another company then you have to figure out whether the acquisition is a consumer monopoly. The rules he uses are that if both companies merge then the debt that was used can be written off very early if the company is very profitable. If a commodity company is acquired then the company uses the cash flow to acquire a consumer monopoly type business and then the management jettisons the cash hungry commodity type business.

4) Does the business consistently earn a high rate of return on shareholders equity?

Warren has figured that high returns on shareholders equity can produce great wealth for shareholders. Thus he invests in companies that consistently earn high returns on shareholders equity. He is looking for a return that is 15% and higher. He thinks that this is a good indication that the management not only can make money from the existing business but also can profitably employ retained earnings to make more money for the shareholders.

Some examples are General Foods with 16%, Hershey Foods with 16.7% and Philip Morris with 30.5%.

5) Does the business get to retain its earnings?

Warren said that he wants to invest in businesses that can retain their earnings and haven’t committed to themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding.

6) How much money does the business have to spend on maintaining the current operations?

Warren wants a business that seldom requires to replace plant and equipment and does not require an on going expensive research and development. He wants a company to produce a product that never goes obsolete and is simple to produce and with little or not competition.

7) How good is the management at reinvesting retained earnings, earnings in business opportunities and expansion of operations?

Warren believes that if a company can employ its retained earnings at above the average rates of return then it is better to keep the earnings in the business. Warren wants to invest in cash cows that are highly profitable businesses with little research and development.

8) Is the company free to adjust prices to inflation?

Warren thinks that a consumer monopoly is free to increase the prices of its products right along with inflation, without it experiencing a decline in demand. Thus profits remain fat, no matter how inflated the economy gets.

Actual Examples of Consumer Monopoly Businesses

Using the 8 Key questions, Warren identified 3 excellent businesses –

1) Businesses that make products that wear out fast or are used up quickly, that have brand appeal, and that merchants have to carry or use to stay in business

Some examples that Warren says are perfect are Coca-Cola, Hershey Foods chocolate, Wrigley gum, and Doritos. These companies no doubt are excellent businesses because almost every convenient store has these products. For clothing Fruit of the Loom, Nike, Hanes and Levi’s are all good.

2) Communications businesses that provide repetitive services manufacturers must use to persuade the public to buy their products

Warren initially invested a great deal of money in Capital Cities and then ABC. These were the only major networks present when he invested in them. Same with newspapers and Warren invested in the Buffalo Evening News.

3) Businesses that provide repetitive consumer services that people and businesses are consistently in need of

Service Master, Rollins, and H & R Block are all good companies that Warren invests in because they provide repetitive services to consumers in times of needs. American Express and Dean Witter Discover were also the ones he invested in. All these companies require very little capital expenditure or a highly paid educated workforce and these is no such thing as product obsolescence. As long as termites keep eating, locusts keep coming, shoppers use credit cards these companies will make money.

Warren thinks that it is hard for inept managers to foul up the economics of the business. He is interested in investing in businesses whose inherent economics are so strong that even fools can run them profitably. Warren identifies these qualities in a manager –

Profitably allocating capital

Keeping the return on equity as high as possible

Paying out retained earnings or spending them on the repurchase of a company’s stock if no investment opportunities present themselves

“Investment is most intelligent when it is most businesslike.”  This is the key idea Warren holds when investing. It means that one stops thinking of the stock market as an end unto itself and begins thinking about the economics of ownership of those businesses that the common stock represents. Warren’s chief idea is to buy excellent businesses at a price that makes business sense. Thus, listening to your stockbroker say that he thinks XYZ stock is a timely buy and that in the last week it has moved up three points, is a total folly. Your stockbroker is only trying to entrap you in the enthusiasm of the horse race of numbers found every morning in the Wall Street Journal. So what makes business sense? Warren thinks it is to invest in businesses with the highest predictable annual compounding rate of return with the least amount of risk. Warren does this better then anyone because he knows that the ownership of the powers of production of the right business is of greater value over the long term then the short term profits usually promoted by Wall Street professionals.

In order to understand Warren’s view of investing from the business perspective, one must first understand his unorthodox view of corporate earnings. Warren considers, for example that if a company earns $5 a share and that if he owns one hundred shares of the company, he has just earned $500 ($5 x 100 =$500). He also believes that the company has the choice of either paying the $500 out to him via a dividend, or retaining those earnings and reinvesting them for him, thus increasing the underlying value of the company. Warren believes that the stock market will see this increase in the underlying value of the company, causing the stock’s price to rise. This view differs from most Wall Street professionals, as they don’t consider earnings theirs until the earnings are paid out in the form of dividends. To Warren, this is plain stupidity as he thinks earning should be retained if the company can profitably employ them at a rate of return that is better than the investor could. Warren also believes that since dividends are taxed as personal income, there is a tax incentive in letting the corporation retain all its earnings. Furthermore, dividend payment would put the earnings in the hands of the investor, which would burden him with the problem of reallocating the capital to new investments.

The rate of return is the actual figure you will be making as an earning from your investment (a number Warren likes to pay close attention to). Warren also pays close attention to the price you pay for a stock, as it is one major factor that will determine your rate of return. In order to calculate the rate of return, another number needed is the yearly per share earning. This is a figure you will not know at the time of purchase, but a figure you will have to predict, or guess. For the obvious reason, Warren likes to invest in companies with reasonably predictable earnings.

To wrap this up, the three variables you will constantly be addressing when using Warren’s system of analysis are:

1. The annual per share earnings figure

2. Its predictability

3. The market price of the security.

Following the three variables system, you will only have to answer two questions when trying to make an investment: What to buy (companies with predictable earnings per share), and at what price?       

This seems simple enough, but there are many Wall Street professionals who go against this analysis. The problem is that many Wall Street investment bankers and brokers function basically as salesmen working for a commission.  For obvious reasons, they want to get the highest price possible for the goods they are selling.  Thus the buyer will most likely not get a bargain.  New issues are priced at the maximum to allow issuing companies to get the most money for its shares and the investment banks to receive the highest commissions.  The stockbrokers on the phone are only interested in selling the priciest item that they can. When a stockbroker is selling you a new issue, you should know immediately that the stock has been fully priced by the investment bank and that you are not getting a bargain.  If a stockbroker is trying to sell you a stock on the prospects of the stock price rising, you must see through that he does not care about what price he sells it to you at all, which is as dumb as you can get in this game.  There is never a stockbroker who will call and say, “ XYZ is an excellent company but its price is too high.”

Understanding this common folly stock brokers and investment bankers try to push us into, when Warren picks and buys stocks, it is as though he goes to a store and determines what he wants to buy, then waits for it to go on sale.  Thus when buying a security, he already knows what companies he would like to own.  All he is waiting for is the right price. For Warren, the “what to buy” question is separate from the “at what price” question. He answers the “what to buy” question first, and then determines if it is the right selling price.

Compounding Rate Of Return

Before going on any further, it is important to explain how the magic of compounding sum of money fits into Warren’s investment philosophy, as his real trick in investing is to get a high annual compounding rate of return.

As you may know, compounding works in a way that if you invested $100,000 in the following way, your return would look like the following.

As seen, the huge difference in returns with just a few percentage point differences over a long period of time is simply amazing. Here is a quick example using compounding.

Let’s say a bond investor puts in $1,000 to General Motors for 5 years at a fixed rate of 8%. The investor receives $80 for five years and at the end of five years will get $1,000 back from GM. The investor would have received $400 in interest. From a tax standpoint, every time the investor receives his $80 from GM, the IRS will consider this as an income tax, lets say around 31%, which means the investor’s after tax yearly return will be $55.20. So after tax, the investor would earn $276 in interest for the five-year period. But this would completely change, if GM, instead of paying out the 8% to the investor and subjecting it to personal income taxes, automatically added it to the principle amount the investor originally loaned the company. In this case, the interest earned will look like the following.

The investor then would be taxed 31%, making his after tax earning into $323.83, which sounds great. However, the IRS also knows about this great trick and will not let you get away with this. But for Warren the IRS missed one very important point, that when buying company equity, (which to Warren is like an bond, only without fixed payments) returns will not be subject to personal income tax unless it is paid out as a dividend to the investor. Going back to the subject of companies retaining earnings, Warren is protected from personal taxes as long as the company does not pay its earnings out as dividends. The earnings that are retained by the company will compound at the effective rate of return, which the company can profitably reinvest.

A little follow up on how serious Warren takes the power of compounding:  Warren is famous for driving older-model cars. In the early days he drove a VW Beetle. If the automobile cost $20,000 today, to the normal people it would be worth almost nothing in ten years. But to Warren, who thinks he can get, say, a 23% annual compounding return on investment, means that the $20,000 invested today will be worth $1,256,412 in ten years, and in thirty years, $9,958,257. To Warren, $9,958,257 is just way too much money to throw away on a new car.

Types of Businesses to Invest In

Taking all this in to account, we will start looking at the kinds of business Warren likes to invest in.  Warren thinks that knowing the kind of business to invest in is the most important aspect of investing. He thinks it is even more important than the price to buy it at. Warren always followed his mentor Graham’s philosophies but later on he adopted the philosophies of Philip Fisher and Charles Munger of investing in companies. Their philosophies were to invest in businesses that have superior economics working in their favor and are selling for the right price. Warren began to follow this. Graham on the other hand thought that all businesses were possible candidates for investments as long as they were selling at a bargain price. Warren saw the problem with Graham’s theory of the realization of value problem. Warren said that if Graham believed the share was worth $62.50 but was selling at $50 then the stock was undervalued by $12.50. If Graham invested in the company at $50 and the stock rose to $62.50 then he would make 25% return on his investment on the first year. But if it dropped then he would lose money. Thus if it keeps dropping, then he loses money and has no returns. This is the realization of the value problem that Warren saw and decided to adopt the principles of Philip Fisher and Charles Munger. Warren felt that the methods of Graham lacked uncertainty and he held holdings that never performed. Some examples of his downward trends based on Graham’s philosophies were Vornado, Sperry & Hutchinson, and Dempster Mill Manufacturing. In some cases however Graham’s theories worked and it gave positive returns but taxes would erode his profit.

Warren began to follow Fisher and Munger’s theories, which was to invest in companies with good economics of business. They said that even though a company sold continuously below its intrinsic value, if the profitability of the company kept improving, eventually the price of the stock would rise to reflect the improved economics of the business. Warren was a true believer of this. A good example of this was when Warren started buying the stock of General Foods, the EPS started increasing as the earnings rose, and the intrinsic value of the company rose as well. With this the stock price rose as well. Under Graham’s theory, Warren might have sold the stock as soon as it started seeing an increase in earnings and then the stock price. But he did not because he considered General Foods is the kind of business that has an expanding value. Even though at times the stock was selling below its intrinsic value, the market price continued to rise. Warren was confident that the market price would rise eventually because the economics of the business would allow the company to experience long-term economic growth, which would be seen in the increasing per share earnings. Warren earned a return of at least 13% and often near 20%.

Warren found that mediocre businesses didn’t have predictable earnings. Even though in the short term the company may have periods of hopeful results, the competitiveness in the business world would rule out any profitability. He found that even though the market did close the gap between market price and the projected intrinsic value, his returns were dull because the gain was limited to the difference between the spread of the intrinsic value and the market price and capital gains tax would also eat his returns. Thus Warren always bought an excellent business with expanding value as opposed to a mediocre business with static value. With an excellent business Warren could hold his investment indefinitely, rather than to get out of it early. By holding it, Warren avoided the capital gains tax to some far of date and enjoyed compounding retained earnings. Here are some examples of his investing in excellent businesses.

The Washington Post is a good example of this. Warren bought 1,727,765 shares in 1973 for $9,731,000 and still has it with him. Today it is worth $600 million, giving him a compounding return of about 18.7%. GEICO is another example of this. He bought $45,713,000 worth of shares in 1972. In 1995, it was worth $1,759,594,000 giving him a compounding rate of 17.2%.

Warren regarded mediocre businesses as commodity type business that produced inferior results with price being the most important motivating factor in the consumer’s buying decision. Some examples are textile manufacturers, steel producers, gas and oil companies, and paper manufacturers. A good example is Company A making improvements in its manufacturing process, which lowers it’s cost of production, which increases its profit margins. Company A then lowers its price of product to gain market share. Companies B, C, D start to lose business and they also do the same thing that Company A did. Thus destroying any profits made by company A. Warren regards commodity type businesses offer the least for future growth of shareholder value. Profits are low because prices are kept low so the money is not there to expand and even if they did make money then the money is spent in upgrading plant and equipment. Identifying a commodity type business is not hard. Warrant regards these characteristics – low profit margins, low returns on equity, difficulty with brand name loyalty, presence of multiple producers, and erratic profits.

The 8 Key Questions In Determining a Consumer Monopoly

Warren regards the excellent business a consumer monopoly. He would invest his money only in this. Warren has 8 key questions that he asks to determine if it is a consumer monopoly, exceptional business economics, and shareholder-oriented management.

1) Does the business have an identifiable consumer monopoly?

By this Warren means that if you go to some convenience store or supermarket and if they carry a brand name, then the chances are that it is a consumer monopoly. Some examples are USA Today, Coca-Cola, and Marlboro cigarettes.

2) Are the earnings of the company strong and showing an upward trend?

Warren is looking for annual per share earnings that are strong and show an upward trend.

3) Is the company conservatively financed?

Warren likes companies that are conservatively financed. He thinks that if a company has a consumer monopoly then it is spinning off tons of cash and is no need of a long-term debt burden. Some examples are Wrigley and UST. In some cases Warren says that if long-term debt is used by a company to acquire another company then you have to figure out whether the acquisition is a consumer monopoly. The rules he uses are that if both companies merge then the debt that was used can be written off very early if the company is very profitable. If a commodity company is acquired then the company uses the cash flow to acquire a consumer monopoly type business and then the management jettisons the cash hungry commodity type business.

4) Does the business consistently earn a high rate of return on shareholders equity?

Warren has figured that high returns on shareholders equity can produce great wealth for shareholders. Thus he invests in companies that consistently earn high returns on shareholders equity. He is looking for a return that is 15% and higher. He thinks that this is a good indication that the management not only can make money from the existing business but also can profitably employ retained earnings to make more money for the shareholders.

Some examples are General Foods with 16%, Hershey Foods with 16.7% and Philip Morris with 30.5%.

5) Does the business get to retain its earnings?

Warren said that he wants to invest in businesses that can retain their earnings and haven’t committed to themselves to paying out a high percentage of their profits as dividends. This way the shareholders can benefit from the full effects of compounding.

6) How much money does the business have to spend on maintaining the current operations?

Warren wants a business that seldom requires to replace plant and equipment and does not require an on going expensive research and development. He wants a company to produce a product that never goes obsolete and is simple to produce and with little or not competition.

7) How good is the management at reinvesting retained earnings, earnings in business opportunities and expansion of operations?

Warren believes that if a company can employ its retained earnings at above the average rates of return then it is better to keep the earnings in the business. Warren wants to invest in cash cows that are highly profitable businesses with little research and development.

8) Is the company free to adjust prices to inflation?

Warren thinks that a consumer monopoly is free to increase the prices of its products right along with inflation, without it experiencing a decline in demand. Thus profits remain fat, no matter how inflated the economy gets.

Actual Examples of Consumer Monopoly Businesses

Using the 8 Key questions, Warren identified 3 excellent businesses –

1) Businesses that make products that wear out fast or are used up quickly, that have brand appeal, and that merchants have to carry or use to stay in business

Some examples that Warren says are perfect are Coca-Cola, Hershey Foods chocolate, Wrigley gum, and Doritos. These companies no doubt are excellent businesses because almost every convenient store has these products. For clothing Fruit of the Loom, Nike, Hanes and Levi’s are all good.

2) Communications businesses that provide repetitive services manufacturers must use to persuade the public to buy their products

Warren initially invested a great deal of money in Capital Cities and then ABC. These were the only major networks present when he invested in them. Same with newspapers and Warren invested in the Buffalo Evening News.

3) Businesses that provide repetitive consumer services that people and businesses are consistently in need of

Service Master, Rollins, and H & R Block are all good companies that Warren invests in because they provide repetitive services to consumers in times of needs. American Express and Dean Witter Discover were also the ones he invested in. All these companies require very little capital expenditure or a highly paid educated workforce and these is no such thing as product obsolescence. As long as termites keep eating, locusts keep coming, shoppers use credit cards these companies will make money.

Warren thinks that it is hard for inept managers to foul up the economics of the business. He is interested in investing in businesses whose inherent economics are so strong that even fools can run them profitably. Warren identifies these qualities in a manager –

Profitably allocating capital

Keeping the return on equity as high as possible

Paying out retained earnings or spending them on the repurchase of a company’s stock if no investment opportunities present themselves