Many superinvestors say that we should buy great companies at fair prices instead of fair businesses at great prices. But what exactly constitutes a great company? Let’s explore the traits of a great business according to my current understanding.
Note that I use company and business synonymously here. I’m not referring to the legal entity, but the business operations of the company.
I think that a great business with poor management is better than a poor business with great management, but worse than a great business with great management. We should be extremely picky in only choosing great companies with great management.
A good manager thinks like a value investor. I’ll define “value” here as the present value of future cash flows of the company, discounted at an appropriate (i.e., risk-free/opportunity cost) rate. Value-investor-managers seek to maximize this present value. This should quell any comparison to growth investing since growth is an integral component of value.
Management is central to the entire business operation. Good management tends to surprise you to the upside, which makes any estimates of the future likely conservative. Think of investing in Amazon before 2006. No one knew about Amazon’s AWS business, but had investors trusted in the vision and competence of Jeff Bezos in exploring new ideas and seeking ways to maximize future cash flows, they would have been richly rewarded. AWS today contributes more than proportionately to the e-commerce business that Amazon is largely known for.
Quality management should display good leadership. Management who come from privileged backgrounds and who feel that they are entitled to more than their fair share of the pie should be ousted right away. Having a good background and being born in the right family/environment or going to prestigious schools is largely just being lucky for being born in the right place at the right time. Their fortunate background may lead to overestimations of their abilities. However, individuals with such fortunate circumstances who stay humble and learn as much as they can from the better opportunities they have been given are likely to be good leaders.
There are many leadership frameworks out there such as Laissez-faire leadership, Servant leadership, and many more. But thinking from first principles, there are some traits that I think form the foundation of good leadership.
Quality management is honest and transparent with their shareholders. They do not make promises without delivering on them. Should they have a change in strategy, they should communicate it clearly and explain the rationale behind it. They should be able to admit their mistakes and learn from them. They should be able to think long-term and not be swayed by short-term fluctuations in the stock price. Companies with shareholder letters and who communicate such ideals are likely to be good prospects for investment.
Management’s actions should reflect their desire to contribute to the overall health and future of the company instead of solely to the size of their pockets. They do not rely on financial accounting trickery to make results look better than they are. Instead, they strive for real growth in the business and hope to be rewarded for it in the long run.
Power corrupts, and absolute power corrupts absolutely. Good management should have checks and balances in place to ensure that no one individual has too much power. This is to prevent any one individual from making decisions that are not in the best interest of the company. The board of directors should be independent and should not be swayed by the CEO’s personal interests. The board should be able to hold the CEO accountable for their actions and should be able to remove them if necessary.
I’ll define here that a part of the “greatness” in great businesses is attributable to the business’s ability to accumulate wealth for us investors. Understandably, this might detract from many otherwise fantastic businesses like Coca-Cola or McDonald’s, which have likely reached their saturation point in terms of growth.
I believe that all investing is value investing. Growth is an integral part of value. We are trying to buy now what we think is worth substantially more if we consider the future cash flows of the business. In other words, if a business generates 25% returns on capital and reinvests all of it back into the business, the business will grow at 25% per year. If we buy such a company at a fair price, we will be rewarded with a 25% return on our investment, which equates roughly to a doubling of our investment every 3 years. So in essence, we have a good estimate that the company is worth much more in the future than it is today, and investing in it now ensures that our investment will eventually grow to our estimate of the company’s intrinsic value.
Giants move slowly. They’ve likely exhausted many opportunities to redeploy their ever-increasing capital at high rates of return. As a result, while they are amazing businesses, they might not be great investments. We should be looking for businesses that are still in their growth phase, where they can reinvest their capital at high rates of return.
Getting a check for $10,000 may mean a lot to many of us, but it means little to a billionaire. The percentage increase in wealth for us is much higher than it is for a billionaire. Similarly, it’s much easier for a small company to benefit from an equivalent opportunity than it is for a large company. It’s hard to fathom how a company like Coca-Cola can 10x its size in the next 10 years. But it’s much easier to imagine a small company with a market cap of $10 million growing to $100 million in the same time frame.
I believe that investing in micro-caps will lead to higher returns than investing in large-caps. Micro-caps are not only advantageous in their size, but also in the fact that they’re less likely to be covered by analysts. This means that there’s a higher chance that the market has mispriced the company, and that we can buy it at a discount to its intrinsic value. Institutional investors may also have artificial limitations that prevent them from owning small-caps due to the perceived higher risks by the population. Eventually, as a micro-cap continues to perform and grow, it will reach a size where institutional investors can invest in it. Along with this will come a great wave of institutional investments that should see a small retail investor’s investment grow substantially.
Of course, larger-sized companies can provide a fantastic return as well. In 2009, Amazon was already at a market cap of 59 billion. Today, it’s at 2.3 trillion. That’s a ~34x return in 16 years despite being a mid to large-cap company back then.
Ultimately, it boils down to what returns on investment the company can still generate. Amazon managed to find multiple ways to reinvest their capital at high rates of return, and that’s what made it a great investment despite being of a larger size.
Show me the incentive and I’ll show you the outcome.
— Charlie Munger
We have to incentivize management and align their interests with us shareholders. It’s important for management to have skin in the game. I love seeing managers with a substantial percentage of their net worth in the company’s stocks and who have stock compensation packages tied to the company’s long-term performance.
Ideally, these managers are not egoistic and do not seek fame over fortune. An egoistic manager may use the company as a stepping stone to create a name for themselves, such as through pursuing expansion at below-cost returns on capital which diminishes the company’s value. They may also use the company’s resources to fund their personal projects or to pay themselves exorbitant salaries.
If a manager seeks fortune over fame instead, and has a substantial portion of their net worth in the company’s stocks, they are likely to be more focused on generating value in the company. We shareholders are simply leeching on these competent managers’ hard work and desire to increase their own wealth.
Customers vote with their wallets for companies that they want to keep around. Eventually, when a company stops providing value to their customers, they will leave and the company will die. A company that provides genuine value to their customers will likely be around for a long time.
Therefore, being customer-centric is highly important and indirectly contributes to increased shareholder value. Companies should never sit on their laurels and hope their past achievements will carry them through the future. They should constantly be innovating and improving their products and services to better serve their customers.
All good things follow from being good to your customers. Provide higher value to your customers, and they will reward you with higher margins, increased loyalty (which contributes to recurring revenue), and by spreading the word about your company’s products, leading to increased sales. Your company builds a strong reputation, opening up more opportunities to partner with other companies or attract top talent. This helps you develop even better products, which in turn makes it easier to increase your returns on capital and the total capital invested.
Alas, all things are easier said than done. Right now, I’m just a keyboard warrior with no real experience aside from my readings and opinions formed thereof. It’s incredibly difficult to be a good manager, much less a great one. But I’ve seen good managers in action in the companies I’m invested in, and I’ve seen the results they’ve produced. Even if we personally can’t be good managers, we can at least build more wealth in the future by choosing to invest only in companies with good management.