5 Things Warren Buffett Looks For In A Business Before Investing

October 14, 2017 8 Ankit Shrivastav

Introduction:

Warren Buffett, The Oracle of Omaha, is one of the richest people in the world, but that is not what makes him stand out from the ever growing crowd of billionaires. What makes Warren Buffett unique is that his company Berkshire Hathaway never sold a product or service. All those billions that Warren Buffett has made, are made by investing in other businesses.

Warren Buffett looks for quality companies that have a sustainable dominant position in the market, and starts investing in them when they are available at a cheap price. What makes his business model interesting is that it is powerful and yet so simple that anyone can do it, even you. What you need to do is follow the exact same principles of investing Warren Buffett followed. There are some common traits that he looks for in a company that help him choose the right business for his investments. What are those traits? Lets understand them one by one:

Durable Competitive Advantage:

A durable competitive advantage are the factors that differentiate the products and services of a company from its peers. A durable competitive advantage can be achieved by creating a strong brand, strong supply chain, wide distribution network and competitive pricing. A durable competitive advantage allows a company to capture bigger market share in its sector, maintain customer loyalty, and give pricing power on the product which helps company gain higher profit margin on products.

For Example, Nestle Indias Maggi brand makes multiple products such as instant noodles, and sauce. The sauce of Maggi have captured almost 50% market share because of its product quality, targeting righ consumer segment (which is urban and semi urban middle class), strong distribution network which makes products available even in smaller cities, and continuous innovation by introducing new and better products, keeping consumers interested. Warren Buffett looks for such companies that have dominated the market because of their unique offering and have the ability to sustain it for long time. Coca cola was one of the investments made by Warren Buffett because it had a durable competitive advantage over other beverage companies.

Warren Buffet invested in Coca Cola because it has a strong competitive advantage over other beverage companies. Coca Cola serve 8 billion 300 ml servings everyday around the world, if it charges one rupee extra for each serving, it will generate Rs. 8 billion extra revenue every day which becomes Rs. 2,920 billion of revenue annually, and I am sure no one would mind paying a rupee extra for one bottle of Coca Cola.

A durable competitive advantage not only helps a company in achieving better financial performance, it also prevents a companys business from being taken over by its peers by building an economic moat around itself. Let us understand what an economic moat is and how it is an advantage for a business.

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Economic Moat:

In medieval times, forts and castles that were prone to foreign invasion adapted a defense mechanism to protect themselves from invaders. They built a ditch around them, mostly filled with water, which prevented the invader from directly accessing the castle.

In the business scenario, an economic moat is the strategy that prevents other businesses from taking over the market share of the company. An economic moat is achieved by creating durable competitive advantage that is explained earlier. Economic moat provides unique customer experience which no other peer company can provide, helping businesses make loyal customer that rely on the brand. In other words, while durable competitive advantage acts as differentiator for the companys business, economic moat uses those advantages to safeguard the business from being taken over by other businesses.

Coca Cola achieved economic moat by creating a unique flavor for its beverages and keeping the preparation formula secret from the world. This not only made coca colas product unique, it also prevented other competitors from duplicating the flavour and taking over coca colas market share. ??

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Long term economics of the sector

A business, no matter how good its products or services are, cannot survive for long if it is not supported by the economics of the sector. Economics of the business are determined by the demand for the product or services, how much a consumer is willing to pay and how long the demand is going to remain sustainable. There are many factors that influence the long term economics of the company, such as, change in consumer preferences, change in technology, change in lifestyle of consumers etc. ?

For Example, back in 90s there were so many video rental service providers where you can simply go and rent the music or movie you want to buy. With the internet revolution, peoples buying preferences changed as they started to download the music online instead of renting it. Due to this, almost all the rental music businesses vanished as the demand of consumers was met by online platforms. Technology redefined the way people consumed entertainment. Similarly, in the future, Tv will lose the battle against the online video streaming services like Youtube and Netflix as they provide high quality content on demand and the viewers don’t have to wait for prime time to watch their favourite shows.

Warren Buffett looks for companies that have sustainable competitive advantage over other businesses. For Example, Warren Buffet invested in Wrigley’s chewing gum company as it had strong long term economics. No matter how the technology panned out in the future, it was not going to influence consumers preferences on which gum they wanted to chew or how they wanted to chew it. Due to this, Warren Buffett had not to worry about how the technological changes would influence the long term economics of Wrigleys chewing gum business and he stayed invested in it for a long time, finally selling his stake to Mars company making multi fold returns.

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Company's position in the sector and its growth potential

The fourth factor Warren Buffett looks at in his investment is the position of the company in the sector and its future growth potential. Company that is a market leader in its segment would make better sales and earn higher profitability compared to a small player which has little influence on the market and has limited reach to its consumers. Company with dominant market share shows that its products or services are in demand among consumers and the company has the ability to reach and cater those demands in an efficient manner. For example, Asian Paints has 54% market share in paints segment, which means, out of every two buckets of paint sold, one of them is an Asian Paint product. This means that products of Asian Paints are trusted by most of the Indian consumers and there is huge a demand for them, which the company is able to cater easily. ?

The second most important aspect of a company that Warren Buffett looks at is the growth potential of the company. A company must keep growing and expand its business to provide better return on investment to its shareholders. There are many factors that determine whether a company will grow in the future or not, such as how the company is ?financed, if a company is largely financed by debt, it becomes a risky investment because if a company is unable to make sufficient profit to pay its debt, there is a good chance that it will go bankrupt. Companies that are conservatively financed (that is which maintain right balance of source of funds between debt and equity) are better investment for future.

Also, a company should post decent growth number in terms of earnings, profitability, and return on invested capital, if a company fails to maintain good growth for considerable amount of time, it definitely will be replaced by someone who can do it.

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Value of business against the market price

The final and the most important criteria that Warren Buffett looks at is the difference between the stock price and the underlying value of the business. The stock price is the price that the market quotes for a single share of the company, which represents the part ownership in the business. The value of the business is the sum total of a business’s net worth, which is constituted by the assets owned by the company, the earnings and profits etc. In the short term, the market tries to predict the future earnings of the business based on the past financial data available, news about the companys future plans and earnings growth etc. Since all these data are merely speculations, the stock price of the company fluctuates as the positive or negative news flows through the market, while the underlying business value of the company remains unchanged for a long time.

An intelligent investor looks for opportunities when the market price of the stock corrects due to temporary negative news but the long term value of the business remains unchanged. This gives investor a good opportunity to invest in quality business when it is trading at a lower price. Buying good business at lower price has two big advantages, first, it provides margin of safety against errors in judging the future performance of the company. Since an investor buys the stock at a discount compared to business’s future earnings, it does not have a significant impact on his return on investment as buying at a discount largely compensates for the error in judgement of future earnings. Secondly, buying stock at a discount also maximizes your potential return on investment. If a company posts numbers better than expected by the market, an investor who has bought the stock at a discount stands to gain better return on his investment because of his low cost of buying, thus maximizing his return on investment.

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Conclusion:

All the criteria mentioned above are used by Warren Buffett when he picks stocks for long term, as he said in one of his speeches, Time is a great ally for a great business, enemy of the mediocre business. when you invest in quality business, it gives compounding returns over a period of time, giving investors multifold returns.

The are many books written on how Warren Buffett picks stock for his long term portfolio (mentioned above) . By reading them and putting his principles and strategies to practice, you too can be a successful investor like him.

Total Comments ( 8 )

  1. arvind says:

    Excellent information in simple wording !

  2. Nisarg Jhadakia says:

    This is the best comprehension of the Buffet Philosophy I have ever come across. Thanks for sharing Ankitbhai.

  3. Zakir Hussain says:

    Very nice .thanks

  4. Giridhar says:

    Simply Superb!

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