I believe to answer this question “generally” is futile. The fact is, each business will have its own “vital few” elements of growth drivers, and is heavily dependent on its interactions and interdependencies to its industry, competitors and its target market. Therefore, I argue that a business cannot be generalized into having a few “elements” in order to succeed.
However, I will instead posit that there are chiefly TWO (2) overarching, vital “natures” that a business should inherently possess that will significantly increase the probability of future success and growth in businesses. These two “natures”, as I will refer to them, will both need to be fulfilled together in tandem, for without one of them, the business would not likely last well into the future under intense competition. You might have expected a (long) list of “elements”… However, I have to disappoint because of the above reasons. However, we should not underestimate what belies these two natures, for its briefness contains deep meaning and multiple nuances. This is, I believe, inspired also from the 80/20 Pareto Principle.
To begin, these two natures that I will elaborate in detail can be well articulated in a quote from one of our favorite value investors, Warren Buffett, who once said: “Our method is very simple. We just try to buy businesses with good-to-superb underlying economics run by honest and able people and buy them at sensible prices.”
Therefore, for the future of a business to thrive, we essentially need to (1) buy excellent businesses with a wide, sustainable moat, and (2) ensure that it is run by management who have utmost integrity and are competent capital allocators. We will spare elaborating on “sensible prices” as it is not relevant to the question of business futures, but rather on investor returns.
The simplicity of this framework of thinking about businesses is astonishing. Even if we do not take Buffett’s word for it, other successful investors have similar processes that follow this structure. Take one of the world’s famous economists of all time – John Maynard Keynes – who said, “As time goes on, I get more and more convinced that the right method of investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”
The next few sections will be explaining those two natures in detail, and highlight the “elements” that likely bring the probability of long-term success for the business way up.
Buy Businesses with Good-to-Superb Underlying Economics
This deceptively simple phrase packs a lot of meaning and nuance behind it. Value investors know first of all, that we must “know what you own, and know why you own it” as Peter Lynch would put it. This means understanding the business model, how revenue and profits are being generated, and what is its cash being used for.
Secondly, and most importantly, we need to identify if there’s a wide economic moat (or durable competitive advantage) underlying the business. Many people talk about this – but in my opinion, it needs to be emphasized even more, and that is what I will do in the later paragraphs.
You will note that I will consciously not mention “elements” such as industry growth, interest rates, social trends and tastes, political changes, environmental factors, or any macroeconomic factors as I believe they do not drive the future of the business in the long run. This is affirmed in one of Buffett’s quotes, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
To ascertain if a business has an economic moat is to understand the business itself – hence “buy[ing] businesses”. We need to know whether the business is a control-based business or a commodity-based business. A commodity-based business is a “me-too” business. It produces “me-too” products that are easily replicable and imitable. Airlines, oil and gas companies are a few examples. Consumers are price-sensitive and have no loyalty to a particular provider. On the other hand, control-based businesses are the opposite. They can contain moats or competitive advantages, and have high pricing power due to consumer “stickiness” (reliance) to the business. Because of this inherent power, these businesses can enjoy higher margins and ride out most macroeconomic waves in the long term. Here, I list FIVE (5) key moats: Businesses that fulfil Constant Needs with strong Brand Names, Economies of Scale, High Switching Costs, Monopolies or Oligopolies, and Network Effect on Proprietary Technologies.
Brand name providers aren’t sufficient – because in today’s world – many companies are smart enough to think about branding. However, if a brand provides a necessity AND/OR is coupled by one of the other moats, then that
brand achieves top-of-mind awareness in its target consumers. The recurring properties of such necessity providers also ensure stability and predictability in earnings and future growth. For example, Coca Cola is one of Buffett’s favorite holdings for many years. The business is simple, it has a strong brand name globally and you are constantly reminded by it when you go to restaurants and order a drink with your meal. when ordering pizza, or even down the street at your favorite grocery store or at a vending machine. Many large pharmaceutical companies such as GSK and Abbott also operate on the same moat.
Economies of Scale can be also translated to the “scalability” of a business. As a business increases its customers, can it adequately and efficiently increase its output? McDonalds does this very well. With a staggering number of global franchises, and its supply all coming from the same supply chain, it can expand its reach easily while reducing average cost of its inventory with each new outlet.
High Switching Costs is growing as a moat – with many businesses taking on the subscription-based business model. We can see this in Netflix, Spotify and Amazon. Traditionally, this used to be network providers such as Verizon and AT&T with their 2-year annual lock-in contracts, however, these businesses have shifted over to more a-la carte services. The fact that all our favorite music playlists, frequently shopped items are on these platforms means that there is consumer reliance to keep using these services – hence contributing to the “stickiness” and subsequently, a high predictability of the business future.
Monopolies and Oligopolies are next. Warren Buffett loves a monopoly as a capitalist. However, these businesses are rare, usually state-controlled and frequently overvalued. For instance, SMRT is the only rail provider in Singapore (which was public until privatized a few years ago). It had the power to raise prices every few years, and while most riders did complain, there was barely any loss of ridership because of consumers’ reliance.
Lastly, Network Effects on Proprietary Technologies have, in recent times, become a new moat that allow a business to grow predictably and exponentially. Network effect means the more people are using a digital platform, the more valuable it becomes. However, that is not sufficient. As we have witnessed, Snapchat had a considerable number of people using its platform but was quickly usurped when Instagram came out with Instagram Stories that rivalled the functions of Snapchat. Hence, the inclusion of “proprietary technology”. A proprietary technology should be patentable, inimitable and scalable. In fact, this moat can be an agglomeration of multiple other moats including “constant needs with strong brand name”, “monopoly” and/or “high switching costs”. One fine example is Tencent’s WeChat platform. A “superapp” in its own right, millions of people rely on this platform every day to pay for goods and services, do banking, communicate and work. At this moment, there are no similar platforms that have the scale or the competencies to rival WeChat.
Honest & Able People
“We look for intelligence, energy, and integrity. If they don’t have the latter, the first two will kill you”Warren Buffett
Buffett’s quote neatly introduces us to this nature/driver of a business. Here, I claim that integrity and competence are two key elements that drive the future of a business.
How do we evaluate an intangible concept like “integrity”? We do it through the lens of what investors call “Alignment of Shareholder Interests”. We can’t guarantee alignment of interest for sure, but a few indicators will
roughly tell us the probabilities of future stability and success of a business run by existing management.
One of them is looking at the key personnel remuneration. Simply put, there is high alignment with shareholders’ interests if we see that management takes a low base pay, but a high variable salary component (which can include share options). Another direct point of reference is looking at management’s personal shareholdings in their own company. If the management are a substantial shareholder, then it is safe to assume they will make decisions that benefit the long-term success and growth of the business – chiefly because they have a personal stake in it.
We can also do background checks on management and also ascertain, from the financial numbers, to see if management has done any manipulation to boost earnings or reduce expenses. Some key financial line items to look out for are the aging of receivables, the buildup of inventory and the writing-off of “one-off” items. This indicates management is not truthful in reporting the facts, and indicates questionable integrity. On the other hand, we would like to see management fulfilling its promises stated in previous years’ annual reports, and admits to its mistakes if they had made a decision that does not benefit stakeholders. Integrity ultimately predicts the future of the business as it gives outsiders a true representation of the business narrative, and assures us that they will make decisions that will not jeopardize the long-term business success for short-term self-serving gains.
Besides integrity, we need management to be competent enough to grow the company by maximally leveraging its moat, and steer it through short-term macroeconomic headwinds and intense competition. Without this
element, it would be like having a supercar with a driver that doesn’t know how to do cool drifts and swerves – ie. the power is there but the people at the helm do not know how to take full advantage of it.
Firstly, management needs to be great capital allocators. Firstly, this means taking a conservative stand in terms of capital structure. A management which does not rely heavily on debt is one that is flexible and can focus on
maximizing its moat. Buffett also agrees, “With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.” Secondly, great capital allocators will put its cash
into decisions that generate long-term value for the business. These are decisions like expansion of stores, factories or facilities, entering into potentially profitable new markets, development of new products, or
acquisition of synergistic businesses. Competent management are like value investors – they are always on the lookout for undervalued opportunities to grow their business. Lastly, a competent management is adaptable and self-aware. They respond to crises and regulations quickly while minimizing loss, try to create a culture of productivity and enjoyability, and are shareholder-friendly. A business is like a ship – if the captains do not steer it well, it will be rocky and difficult to navigate choppy waters. It might even go off-course or worse, sink. A competent management takes care of its crew and ensures a smooth ride for its passengers, while being adaptable to steer through rough waters and can even navigate the ship to unchartered waters in search for treasures.
In conclusion, the futures of a business albeit uncertain, can be presumed with high accuracy if we consider the above 3-step framework implicit in Buffett’s quote. There can be many “elements” specific to each company’s
future, however, using this framework, we can see that those specific “vital few” elements that truly drive a particular business can be attributed to just two (2) natures – the sustainable competitive advantage and an honest and able management. And to end off, as Charlie Munger might say, we have nothing to add to that.