The best way to become a good investor is to buy good companies. But how do you find these good companies? What qualities should you be looking for in a high-quality business?
Every successful investor has their own framework they use to find these businesses based on their specific skill sets. For example, Warren Buffett (Trades, Portfolio) tends to focus on companies that are more consumer-facing than say, Carl Ichan, who tends to focus on undervalued industrials (although he does also target firms in other sectors if he believes they are undervalued enough).
Charlie Munger's markers of a good business
In "Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger," there's a list of the four qualities that Charlie Munger (Trades, Portfolio) believes are the marks of good businesses:
"A) Extreme maximization or minimization of one or two variables. Example, Costco or our furniture and appliance store."
In both of these examples, the company is offering exceptionally low priced goods to customers, and this is its competitive advantage. Costco makes virtually all of its money on customer subscription fees. Prices are so low customers cannot help but sign up. At the same time, prices at the Nebraska Furniture Mart are so low that customers flock to its stores, even though the products may be a little rough around the edges.
"B) Adding success factors so that a bigger combination drives success, often in nonlinear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result."
This quality is a little harder to determine in businesses. Most companies start up small, and as they grow, operating efficiencies translate into fat profit margins and bigger profits.
Cloud computing is a fantastic example of this phenomenon in action. Once the initial start-up costs are covered, every extra dollar of revenue goes straight to the bottom line.
Apple has been able to replicate a similar effect with its subscription services. However, picking these companies when they are small is the challenging part.
"C) An extreme of good performance over many factors. Example, Toyota or Les Schwab."
Les Schwab and Toyota (TM) are both businesses that do everything very well. The Toyota business model is focused on producing superior quality at a lower cost than its competitors by following a set of principles based on problem solving, people, the process and philosophy of the business.
Les Schwab Tire Centers used a similar approach. It built customer loyalty with excellent service and low cost. Moreover, the firm put its people first, giving employees 50% of their store's profit.
Businesses that have these qualities are scarce. When you find them, it makes a lot of sense to buy them and, in the words of Munger himself, "sit on your ass."
"D) Catching and riding some sort of big wave. Example, Oracle."
Companies that catch a big wave are set for success, but picking these stocks is challenging for investors. If they fall outside of your circle of competence, it could fall into the realm of speculation.
Still, if you can find a business that is both on the edge of a big wave and has all of the other qualities listed above, that could be a lollapalooza. Coca-Cola arguably fell into this category in the 1980s. The company had a good product at a low cost and impressive global economies of scale.
At the same time, the business had a well-run operation and a massive share of mind among consumers. And finally, the company caught the wave of global refrigeration, the globalization of trade and population growth.
All of these factors helped the firm's net income explode from $2.1 billion in 2000 to $9 billion in 2011; a great case study of Munger's four qualities of a good business in action.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Charlie Munger's Three Tips for Valuing Stocks
- Buffett's Advice for Improving Your Strategy: Keep Reading and Learning
- Ben Graham: Don't Chase Fashion Stocks
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