Sunday, November 30, 2014

Hallmarks of a great business

Hey guys, how are y’all doing? I’ve recently been chillaxing, researching companies and pondering really important stuff like which fictional character I would want to be my girl. Right now I’m stuck between Elsa from Once Upon a Time and Caroline Channing from 2 Broke Girls. Anyway, I think that it’s good to take a step back every once in a while and get back to basics. That’s why I decided to come up with a list of things that make a business great. A business might not need all of these things to be great, but it definitely needs at least one or more of them.

Update on the Greedy Dragon portfolio: I recently bought shares in Alpha Natural Resources (a coal miner). But knowing my fucking luck, the stock went ahead and dropped another 7% from the price I bought it the very next day. I obviously think that the company is able to survive this period of depressed coal prices. But I could be wrong. The stock may still drop significantly in price or maybe even go bankrupt. Do your own research before investing in anything.

Asset-light: A great business doesn’t require a lot of capital to be tied up in stuff like inventory, accounts receivable and property, plant & equipment. The asset-light business is able to expand rapidly as each dollar reinvested in it goes much further than it would for a capital intensive business. Asset-light businesses also do not have to incur large capital expenditures to maintain their operations, which results in them generating more free cash flow that they can return to shareholders or use for expansion. Finding an undervalued, asset-light company with lots of free cash flow makes me about as happy as when I discovered the KFC Double Down.           

Pricing power: A great business is able to increase the price of its products at a rate that’s higher than the inflation rate over the long-term (with little to no loss in sales volume). One example of a business with pricing power is See’s Candies (which was bought a long time ago by el jefe of value investing, Warren Buffett). The ability to consistently increase prices at a higher rate than inflation allowed See’s Candies to grow profits at a very satisfactory pace (despite its low volume growth) and turn into an awesome cash cow.

Revenue growth from simply increasing the price of its products comes at a lower cost to the business as compared to growth from increased sales volume. This is the case as the business doesn’t have to invest in inventory or capacity expansion to enjoy the extra revenue from price increases. Pricing power is especially important for a mature business to grow its profits at a healthy rate as the contribution to growth from sales volume increases would be lesser.

Sustainable competitive advantage: A business is considered great for the obvious reason that it is a shit ton more profitable than most of its competitors. To achieve superior profitability, a business needs to have a durable competitive advantage. A few examples of a competitive advantage are a strong brand, patents, licenses, unique assets (example: a very popular shopping mall in the middle of the country’s main shopping street), specialized capabilities and a low cost structure (this can come from stuff like economies of scale, efficient systems and/or industry-related advantages such as a large low-cost deposit base for a bank).

Scalable: A great business is able to quickly expand its operations with a lower corresponding increase in costs and capital employed. A popular restaurant franchisor is able to grow rapidly as its franchisees are responsible for putting up the capital and incurring the costs to open and operate new restaurants. Another example of a scalable business is a software developer where it takes a lot of time and money to develop the software, but the marginal cost of selling the software to customers is very low.

A lot of great companies have already grown into large blue chips. And I’m pretty sure that those mature great companies should still deliver decent long-term returns if bought at reasonable prices. But if you want to make “fuck everybody” money, you need to find a great company (or a potential great company) that still has a lot of room to grow.

Oil stocks sure took a beating on Friday. That certainly motivated me to finally start learning more about the oil industry and researching oil companies. As always, thank you for reading. Take care and stay rational.  

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