From a conceptual point of view, your goal is to find and invest boldly in businesses that have the following traits:
1) Wonderful businesses with durable competitive advantages
Essentially, what you are looking for is a company with an impenetrable competitive advantage, also called “wide moat”. This moat can be in the form of strong reach or pricing power, a network effect of some sort, a strong brand, or some other strong competitive advantage. The bottom line is that when you consider the strength of the business, you must first consider how durable it’s business model going into the long-term future is. Ask yourself this question: How difficult would it be for an existing or future competitor to take business from it, either by copying a product or service or by inventing or using a disruptive technology? Let’s take a look at a few examples:
Boeing (BA): Wide moat
- Airlines and flyers want aircraft from reputed manufacturers for safety reasons
- Building aircraft is extremely difficult and costly
- Boeing has amassed a wide array of aviation patents over the years
- Wide network of pilots who know how to fly boeing aircraft creates a network effect
- Boeing has the largest building in the world to build aircraft in, and can produce aircraft at a faster pace than any other company in the world
- Difficult to create a comparable aircraft as cost-effectively as Boeing due to economies of scale
The Coca-Cola Company (KO): Wide moat
- Strong brand and extremely loyal customer base
- Strong and broad reach: sold in literally every shop, restaurant, bar, gas station, rest stop in the world
- Pricing power (they can and do raise prices reasonably whenever it is required, generating more revenue)
- High margins on high volume allow for an astronomically high marketing budget, making it difficult for competitors to compete
- Economies of scale means it is difficult to produce Cola at cheaper prices than Coke does
- Drowning in cash that can be used to purchase smaller companies or portions of smaller companies like Monster and Green Mountain Coffee (Keurig)
American Express (AXP): Wide moat
- Large network of merchants and members makes it almost impossible to penetrate the payments market (chicken vs. egg problem)
- Strong brand with high-earning members
- Members pay a membership fee to have a card despite free use of other cards – indicative of the strength of the brand
- Able to extract a higher “discount” from merchants due to high-earning members
JC Penney (JCP): No moat
- People usually don’t have loyalty to any particular store
- Very little differentiation between a store like JC Penney and Macy’s, making them essentially commodity businesses who compete on price and availability
- Difficult to get fashion right every single time, season after season
- How do they compete with more efficient online retailers like Amazon.com?
2) Businesses that are able and willing to return a significant amount of their earnings to their shareholders
After you have found a wide moat business with a durable competitive advantage, you need to distinguish between businesses that must reinvest their profit to sustain their revenue and businesses that don’t. Preferably, businesses should be able to distribute their earnings to shareholders (you) via dividends and/or share buybacks.
For example, let’s take the first business from the list above, Boeing. Although Boeing is a great business with wide moat, in 2013 it spent 48.8% of its net profit in capital expenditures – after all, building an aircraft is very difficult! On the other hand, American Express and Coca-Cola spent 18% and 29% in capital expenditures in 2013 respectively. This means that they are able to retain a large portion of their profit to invest in other things or distribute to the shareholders.
Truly wonderful companies have (1) wide moat and (2) low capital expenditures. If you pick companies that fall into these categories and hold them for the long run, you will most certainly outperform the market. The difficult part is being truthful in your assessment of a company’s moat.