Five Characteristics of a Great Business
What makes a business great? This is one of the the key questions to ask when looking to invest your dollars in the common stock of a publicly traded company. Obviously, the goal of any business is to create capital where there was none before; i.e., generate profits. However, just because a company is profitable today does not necessarily mean it will be profitable tomorrow. Good investments are made in companies that can sustain profitability over a period of time, and are not prone to swift and painful loss of business.
Here are 5 primary factors to look for when evaluating a potential investment in terms of determining whether or not it is a great business:
- Recurring Sales
One way to guard against a sudden loss of business is to employ a recurring revenue business model. There are numerous examples of this: consumable products (food, beverages, toiletries, etc.), subscription media, open-ended prescription drugs, business services such as outsourcing payroll, consumer services like cable TV and broadband internet, and so on. All of these businesses generate recurring revenues from customers on an annual or monthly basis, and so are not necessarily reliant on their product being the "hot" item at the moment.
Conversely, there are lots of businesses that must constantly compete to win business, and after winning it, they rarely see more sales to the same customer. One Magic Formula example of this is LCA-Vision (LCAV), which provides laser eye correction surgery. It's pretty unlikely that most customers will need (or want) to have their vision corrected twice!
- Scalability at Low Cost
Growth is an important factor to consider, but the cost of growing is very important to the ultimate outcome. Truly great businesses can increase revenues without spending a whole lot to do so. Take, for example, eBay (EBAY). Here is a company that does nearly all of it's business on the internet, and basically just connects buyers and sellers together. Once the servers, databases, and software were in place, eBay could accommodate ever larger numbers of customers without spending much of anything! This is scalability at low cost.
Compare this to the airlines, a notoriously bad business. For the airlines to grow revenues, they have to add routes. Adding routes requires massive capital spending for new planes, airport terminal space, regulatory rights, and so forth. Growing revenues is a very expensive proposition - airlines cannot scale without spending a lot of money to do so. Clearly eBay's way is a lot better!
- High Return on Invested Capital
Think about what your goal is when you invest in a stock, or a mutual fund, or a piece of real estate. You are looking for high returns on your investment, right? The same applies to businesses. Simply put, businesses invest capital to earn a return. A business that can earn a higher return on the capital it invests is a better business. Most Magic Formula companies earn returns of 30% or higher on invested capital.
This point is core to the Magic Formula screen. The mantra of the Magic Formula Investing strategy is "good companies at cheap prices". The "good companies" part is measured by return on invested capital. The airlines vs. eBay example applies here as well. For every server eBay buys, they can earn a substantial return on that investment. For every plane the airlines purchase, there is less upside because of maintenance costs and the limited time and space available at any given time. Which brings us to our next point...
- High Cash Flow Margins after Maintenance
Cash flow is what it's all about... this is the capital that a business can re-invest to earn those return on capital figures, or pay back to the shareholders in the form a dividend or repurchase of shares. Good companies can convert a high percentage of their sales into free cash flow - cash left after maintenance costs to keep the business going. MagicDiligence usually looks for free cash flow margins to be over 5%, although this figure depends on the type of business.
Let's pick on the airlines again here. Maintaining airplanes is an expensive proposition. Planes have to work flawlessly, which requires a lot of spending for parts, labor, tools, and so on, and in every location the planes fly to or from. All of this eats up the cash earned from ticket sales, and leaves little left for the business to re-invest or pay back. eBay's maintenance costs are much less obtrusive. Maintaining computer equipment and software is considerably cheaper. Therefore eBay will have more cash left over to invest (unfortunately, the company has often chosen to use that cash to make insanely expensive purchases of other businesses).
- Durable, Structural Competitive Advantages
All of these attributes of a good business are worthless unless they are attributes that can be sustained over a long period of time. Otherwise they can disappear and we're left owning a not-so-good business.
So what attributes inherent in the business provide these durable and structural advantages? A good place to start is to read Pat Dorsey's excellent book The Little Book That Builds Wealth (read the MagicDiligence review). Dorsey shows how things like regulatory limitations, the network effect, and intangible assets like brands can protect a company's sales from competition. This allows the business to maintain high returns on captial, which will ultimately lead to higher profits and higher returns for shareholders.
The Magic Formula automatically finds candidates that may be great businesses using the return on capital statistic. It's up to the investor to determine the other characteristics. That's where MagicDiligence comes in. MD analyzes Magic Formula stocks looking for these 5 characteristics, and recommends only those stocks that pass the test. Learn more or see all MD picks with a FREE 30-day trial.
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