Thursday, March 12, 2015

What distinguishes a first-class business from an ordinary business?

From Deep Value:
In a cruel irony, most good businesses earning high returns on invested capital can’t absorb much incremental capital without reducing those high returns, while most bad businesses earning low returns on invested capital require all earnings be reinvested simply to keep up with inflation. Bad businesses that can only earn sub-par returns destroy capital until they are liquidated. The sooner the business is liquidated, the more value that can be salvaged. The longer the good business can maintain a high return on invested capital, the more valuable the business. What then distinguishes the first-class business from the ordinary business? The differentiator is not simply high returns on capital, which, as Graham pointed out, even an ordinary business will earn at some point in the business cycle, but sustainable high returns on capital throughout successive business cycles. The sustainability of high returns depends on the business possessing good economics protected by an enduring competitive advantage, or what Buffett describes as “economic castles protected by unbreachable ‘moats.’”