Source: Qilehui
Author: Changpo Xue

Let's take a look at the types of companies that can impress us. At the same time, we will also discuss which companies we hope to avoid.

The companies that Charlie and I are looking for are a) businesses we can understand; b) have good long-term prospects; c) management that is both ethical and capable; d) reasonable stock prices.

1. Own a piece of the 'Hope Diamond'

We tend to buy the entire company or at least 80% of the shares when the management team is our partner. If an outright acquisition is not feasible, we are also happy to buy a small portion of great companies in the securities market, just as having a small piece of the "Hope Diamond" is better than owning an entire "Rhinestone" (a type of synthetic diamond).

2. What is a moat?

A truly great company must have a "moat" to protect the investment and obtain good returns. However, the dynamics of capitalism mean that any business "castle" that can earn high returns will be repeatedly attacked by competitors. Therefore, an insurmountable barrier, such as becoming a low-cost provider like Geico Insurance or Costco, or having strong, globally recognized brands like Coca-Cola, Geely, and American Express, is fundamental for a company's sustained success.

Business history is filled with companies that shine brightly like "Roman fireworks," whose so-called "long moats" ultimately prove to be illusions and are quickly crossed by competitors.

Our judgment criteria for "sustainability" have excluded many companies in rapidly developing and constantly changing industries. Although capitalism's "creative destruction" is beneficial for social development, it eliminates the certainty of investment. A "moat" that needs to be constantly dug again and again ultimately amounts to having no moat at all.

3. Management is not a moat.

Additionally, this standard also excludes companies that can only succeed by relying on a great manager. Of course, a CEO that instills fear in competitors is a tremendous asset to any company. At Berkshire, we have a considerable number of such managers. Their abilities create substantial wealth, something that cannot be achieved through general CEOs running the operations.

However, if a business relies on a superstar to achieve good results, that business itself will not be considered a good business.

A medical partnership company led by the chief neurosurgeon in your area may have impressive and growing revenue, but that does not indicate much about its future. With the departure of the surgeon, the partnership's "barriers" disappear as well; even if you cannot name the CEO of the Mayo Clinic (one of the best hospitals in the USA), you can estimate how long its "barriers" will last.

4. What does a good business look like?

The businesses we are looking for are companies with long-term competitive advantages in stable industries. If they grow rapidly, that’s even better. But even without growth, such businesses are still worthwhile. We can simply use the substantial profits gained from these businesses to purchase similar companies elsewhere. There is no rule that states you must spend money where it was earned.

In fact, this approach is often a mistake: truly great businesses not only achieve significant returns from tangible assets, but also do not need to reinvest a large portion of their earnings to maintain high ROI over any duration.

Let's take a look at the prototype of this dreamlike business - the Hershey Confectioners Company we own.

The operation of the boxed chocolate industry is not exciting at all: in the USA, the per capita consumption is very low and has not grown. Many once-famous brands have disappeared, and only three companies have earned more than a symbolic profit in the past 40 years. Truly, I believe that despite most of Hershey's income coming from a few states, it accounts for nearly half of the entire industry’s revenue.

When the Blue Chip Stamp Company bought Hershey Confectioners in 1972, it was selling 16 million pounds of candy. (At that time, Charlie and I controlled the Blue Chip Stamp Company, which was later merged into Berkshire), Hershey's sales last year were 31 million pounds, with an annual growth rate of only 2%. However, the lasting competitive advantage established by the Hershey family over 50 years was later solidified by Chuck Huggins and Brad Kinstler, creating extraordinary results for Berkshire.

When we bought it for $25 million, its sales were $30 million, and its pre-tax income was less than $5 million. The company's operation, with capital of $8 million (there are a few months each year where it requires moderate seasonal debt). Since then, the company has earned 60% of pre-tax income on invested capital. Two factors aided in the minimization of working capital. First, the product is sold for cash, eliminating accounts receivable; second, the production and distribution cycles are very short, minimizing inventory.

Last year, Hershey's sales were $0.383 billion, with a pre-tax profit of $82 million and working capital of $40 million. This means that since 1972, we had to reinvest only $32 million to accommodate its modest scale growth and slightly excessive financial growth. At the same time, total pre-tax earnings amounted to $1.35 billion, and after deducting $32 million, all those earnings flowed to Berkshire (or the earlier Blue Chip Stamp Company).

After paying corporate taxes on profits, we used the remaining money to buy other attractive companies. Just like the activities originally favored by Adam and Eve, which produced 6 billion people, Hershey Confectioners opened the door to many new streams of revenue for us later on. (For Berkshire, it is like the Bible says: "the land was fertile, and it multiplied greatly").

In the USA, there are not many businesses like Hershey Confectioners. Generally, it takes an investment of $0.4 billion or more to increase the company's revenue from $5 million to $82 million. This is because a growing business needs more working capital due to rising sales and also requires more investment in fixed assets.

Whether a company’s capital requirements for growth have significantly increased is just as telling regarding whether it can be a satisfactory investment. Returning to our example, a company that can earn $82 million in pre-tax income on a tangible asset net worth of $0.4 billion is indeed nothing to be ashamed of, although its owners’ cash balance sheets are completely different from that of Hershey Confectioners. Owning a business that generates substantial cash flow without requiring a large capital investment is truly fantastic! Just ask Microsoft or Google!

What does a good business look like?

An example of a good but not extraordinary business is the FlightSafety company that we own.

This company creates benefits for its consumers, just like other similar companies I know. It also has a lasting competitive advantage: participating in flight training, which is like being overly concerned about price before a surgical operation when choosing another company instead of this top flight training company.

Of course, this business needs to reinvest a large portion of its income in order to grow. When we bought FlightSafety in 1996, its pre-tax operating income was $0.111 billion, with a net investment in fixed assets of $0.57 billion. Since we acquired it, after accounting for a total of $0.923 billion in depreciation, total capital expenditures amounted to $1.635 billion, most of which was used to purchase flight training simulators to keep up with the frequently mentioned new models of aircraft.

(A simulator costs over $12 million, and we have 273 of them), now our fixed assets, after depreciation, amount to $1.079 billion. The pre-tax operating income reached $0.27 billion in 2007, an increase of $0.159 billion compared to 1996. The return this income brings us is decent compared to the $0.509 billion investment we have increased, but it is simply incomparable to what Coca-Cola has brought us.

Therefore, if we solely calculate economic returns, FlightSafety is a good but certainly not an extraordinary business. The experience of high input and high output it reflects is what many companies face.

For example, when investing in utility companies, our huge inputs quickly depreciate. In the next ten years, we can earn quite a bit of money from this business, but we need to invest billions of dollars to achieve it.

What does a bad business look like?

Now let's talk about bad businesses. A relatively poor business is one that, although its revenue is growing rapidly, requires huge investments to maintain that growth, and afterwards earns very little or even makes no money at all.

Think about the aviation industry, from the day the Wright brothers successfully flew to now, the so-called competitive advantage of this industry has been proven to be purely nonexistent. In fact, if there had been a visionary capitalist in Kitty Hawk (where the Wright brothers conducted their test flights) at that time, he should have taken down Oliver Wright, greatly helping his successors.

Since the moment an airline launches its first flight, its demand for capital has been insatiable. When investors should avoid it, they are often attracted by the company's growth, continuously pouring money into this bottomless pit.

I, too, shamefully joined this foolish activity. In 1989, I let Berkshire buy preferred shares of American Airlines. But before the ink on the check could dry, American Airlines began its downward spiral, and soon it stopped paying us dividends on the preferred shares.

However, in the end, we were quite lucky. During another round of misguided optimism towards airlines, we sold our stocks in 1998 and ended up making a substantial profit.

In the 10 years following our sale, American Airlines filed for bankruptcy twice!

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Author's comment:

1. One should always Buy good Businesses; having a part of a diamond of hope is better than owning a whole synthetic diamond.

2. Low cost and strong branding are the true moats of a company, while excellent management is a false moat.

3. A business that relies on superstars and excellent management for greatness is not the best business by itself.

4. An excellent business is a company in a stable industry with a long-term competitive advantage; it can achieve significant returns from tangible Assets without needing large investments to maintain its high ROI. To translate: Excellent business = stable industry + monopolistic company + high ROE + low investment with high output. Savor the examples of Confectioners and Coca-Cola, then appreciate the liquor business in China, especially Kweichow Moutai.

5. A good business is high input and high output; to maintain growth, a portion of the profits must be reinvested. Everyone can ponder over the example of Fei'an Company in the text.

6. A bad business is high input with low output; such a business sees rapid revenue growth, but requires massive investment to sustain that growth, ending up with little profit or even no money made. An example given by Buffett is Airlines.

编辑/jayden