What Makes a Good Business?

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Apr 30, 2011
A good business isn't a business that makes the best mousetrap. A good business is a business that can make the second-best mousetrap and still sell it as if it was number one.


Someone who reads my blog sent me this email:


Today, I read about your stock analysis process in your blog and there are some sentences that I do not really understand.


1. "Do you make capital goods? That's bad" - my best guess is capital goods are infrequent, big ticket purchases but I wonder whether quality is an important factor in procuring decision.


2. "Do you distribute? Good. Produce? Bad" - I actually think distributing is a mediocre business.


3. "I look for business descriptions that sound non-capital intensive" - I think high fixed cost can create a barrier to entry.


I hope you can explain these sentences further to me.


Okay.


I think we see business a little differently in terms of what a good business is. We may just have to agree to disagree on some of these points. But let me try to explain my thinking.


1. "Do you make capital goods? That's bad" - my best guess is capital goods are infrequent, big ticket purchases but I wonder whether quality is an important factor in procuring decision.


Sure. Quality is important. But measurable quality is easy for competitors to copy. Look at how many dominant capital goods companies have competitors that were founded by former employees of the original market leader. Sometimes in the same town/state!


Can you really ever protect quality if you will eventually face your own ex-employees?


It's usually easier to get an advantage over your existing customers rather than some super safe defense against future competitors. You want both. But, if profits only go to the quality leader in the industry – competition is going to be a constant threat.


I don't mind buying a stock that makes the best mousetrap. But if the company's only hold on its customers is that it makes the best mousetrap - that's actually not a good business.


A good business isn't a business that makes the best mousetrap. A good business is a business that can make the second-best mousetrap and still sell it as if it was number one.


Google (GOOG, Financial) is a good business because a better search engine can't kill it anymore. It matters how good Google is at search. But only a little bit. If Google makes a decent search engine and Microsoft (MSFT, Financial) makes a great search engine, Google will still win. That's the defining mark of a good business.


The search process is either irrational or based on things the searching customer can’t possibly know – and doesn’t really try to know – for himself. Social proof. Just assume everybody else’s reasoning is right. Save yourself the trouble of thinking.


Let’s look at the ultimate social proof business: college.


Look at the best American colleges in 2011. The position each holds today is mostly due to being an early leader in a particular region (local market) – or among an up till then educationally underserved group – usually a religious sect or business profession (market segment). And when I say early, I mean early. Here are the schools created before the revolution: Harvard, William & Mary, Yale, Pennsylvania, Princeton, Columbia, Brown, Rutgers, Dartmouth.


That’s awfully close to a modern list of the best colleges in the country. The obvious exception is that colleges from regions that hadn’t been settled by 1776 have been added to the list over time.


In fact, just about the only way anybody became a top school in a region that already had colleges was by being willing to teach subjects (like technology) or students (like Catholics) that the top guys couldn’t handle real well.


As investors, we want to own businesses that are like colleges. Businesses where it’s tough for new customers to know which product is best.


They don’t know which product is best. So they look around at everybody else. Everybody else is using our product. So they figure they might as well use our product too.


This kind of behavior provides a competitive loophole. The problem for most businesses is that customers search for substitutes. They comparison shop. We don’t want that. We need a way to stop any new instances of comparison shopping. We could try to keep our competitor’s products off the shelves. But that’s too hard. Competitors are hard to misdirect. They’re too invested, too attentive, too motivated.


Customers don’t have to be.


But capital goods customers are more invested, attentive, and motivated than most customers. They’re too rational.


Capital goods have rational buyers. We want irrational buyers. Capital goods buyers - the actual person who makes the yes/no/price decision - are often employees whose entire job (or a big focus of it at the moment) is making purchase decisions like this. Would you want to have someone like that across the bargaining table? I wouldn't.


I want passionate buyers - or at least inattentive buyers - rather than rational, attentive buyers. Profits come from the willingness of the buyer to give up more cash than the seller gave up to get the product in the first place.


In capital goods, there's someone working hard not to overpay. That worries me. The level of intelligence the buyer has (information they’ve gathered to use when bargaining) also worries me. Overall, you've got someone across the table who's rational, attentive, and motivated to drive a hard bargain.


Usually, there’s not much money in bargaining with somebody like that.


The psychology of capital goods exchanges are not good for the seller. It's a very level bargaining table. And, obviously, the chance that the buyer (your customer) engages in almost constant searches for alternatives is a big risk. The best way to keep a customer (without a price concession) is to stop them from searching for other alternatives.


I just think that's hard to do in capital goods.


Profit is the ability to charge a customer more for your output than your input. It's hard to control the input and I'm dubious of alleged competitive advantages based on access to superior quality/lower cost inputs. So, basically it's what you are doing inside the box between input and output to make a more useful product and then the bargaining power (advantages in rationality, attention, information, motivation, etc.) that you have at the sale point that is going to decide how much money you make in any business.


I don't usually see the possibility for extraordinary profits in capital goods. But there are some exceptions.


Many of those exceptions are due to the place your capital good has in the end system - and yes, it's often going to be a system or at least an extremely complex final product that a super profitable capital good is going into. Some of the best capital goods businesses are demon dust businesses.


In a demon dust business – the per unit cost contributed by the capital good is a small part of the cost of the finished product; however, failure of the capital good results in failure of the finished product. Also, there are - very rarely, but it happens - some pixie dust capital good businesses like Graco (GGG, Financial).


In a pixie dust business – the per unit cost contributed by the capital good is a small part of the cost of the finished product; however, success of the capital good results in an outsized influence on the success of the final product. Graco's products have an outsized influence (relative to its cost) on the end customer's perception of the finished product. At least compared to most capital goods. Graco is about the closest you’re going to get to a pixie dust business in the capital goods business.


If you look at some of the most profitable capital good companies – the closer you look the more you see that the extraordinary profits they earn tend to come from either a consumable ("blade") or a service (maintenance).


One of my favorite business books is Hidden Champions of the 21st Century. My one problem with that book was the way the author correctly sees the fact that some of his (German) hidden champions aren't exceptionally profitable but then fails to see that this is probably due to their being dominant players (big relative market share) in capital good businesses rather than other industries.


The likely explanation is that high relative market share does not always lead to as good overall profitability in capital goods as it would in say a branded consumer business. Put another way, these hidden champions are often big fish in slightly less attractive ponds. If you had the position they had in an industry where you are actually in contact with the end consumer - you might earn better returns on capital.


2. "Do you distribute? Good. Produce? Bad" - I actually think distributing is a mediocre business.


A lot of people think that. I'm not sure why. I guess they think it's easy to copy a distributor. Of course, a distributor is just a connection between customers and their inputs. So, a distributor's value is entirely found in the panoply of inputs it offers and the problem that solves for its customers. Margins are low. And a lot of people do tend to focus on sales margins rather than asset turns. I'm not saying distributors are necessarily good businesses – any more than producers - but the first thing you want to control in any industry is the distribution rather than the production.


Production is the least chokiest choke point in an economic chain.


Production is really not the way you want to enter any industry. Now, when you say distributing is a mediocre business I assume you're talking about companies we call distributors. But, actually, distribution is often a part of many good businesses that we don’t call distributors.


Think about shoes. The distribution part of the business is going to be important to any shoe company you buy. Production may or may not be. It’s usually the easiest part of the chain to toss out.


Personally, I think a lot of folks overestimate the value of independent producers and underestimate the value of distribution. Integrated production is a different story. But independent production is not as good a business as a lot of investors assume it would be. Most of the "producers" that people consider good businesses are actually integrated and as much about distribution as production in terms of where they're adding economic value.


Let’s look at some of history’s famous integrated businesses. MCA didn't start out as a TV studio. It started as a talent agency. It wasn't even in the right business (it started booking live music then moved to music for radio) or the right city (it started in Chicago). But it got to be a pretty big integrated producer. Same with Standard Oil. It started - and became dominant - about as far from the production side of things as you could get.


My view of where it's best to be in terms of production/distribution is summed up by Vanderbilt's railroad career. He bought a run-down, worthless road (the Harlem) because it controlled the only rail line into Manhattan. The lesson: find the choke point and take it.


Production is the toughest part of any industry to choke off. That’s why I'm often dubious of profits coming from production alone.


3. "I look for business descriptions that sound non-capital intensive" - I think high fixed cost can create a barrier to entry.


And exit. I don't want to wake up in a roach motel. You want to invest in industries where it's hard to check in but easy to check out. Not businesses where it's hard to do either.


Competitors need to be able to leave the industry as soon as profitability is inadequate. We don't want a lot of sunk capital hanging around. U.S. Steel and AT&T were basically not for profit corporations. Their shareholders could have made more money elsewhere. The businesses were constantly worth less in the stock market than the capital that had been put into them. I don't want to own a charitable monopoly like that.


Fixed cost intangible are betters.


"At BASF we don't make a lot of the products you buy. We make a lot of the products you buy better."


That's worth the price of a chemical plant right there. And there's nothing to shutter. You just stop running the ads. And the memory slowly fades from people's minds. Not a bad place to sink your money.


Think of all the companies that built up a name in one industry only to move on to another industry and bring the public's goodwill with them.


Berkshire Hathaway owns two of them: American Express (AXP, Financial) and Wells Fargo (WFC, Financial).


Those are both businesses that hitched their wagon to growth industries without having to put up much fixed, tangible capital.


The rule of thumb is that whenever you become completely convinced of the long-term growth of some earthshattering industry you take the soft side.


The list of companies who've been around for 50, 100, or 150 years and still manage to earn above-average profits is basically a list of folks who got a snowball of intangible assets started real early on and just kept it rolling ever since.


It's the opposite of guys like U.S. Steel and AT&T.


They had all sorts of competitive advantages. And yet they managed to take dollars of shareholders equity and turn them into mere cents in the stock market.


You don’t want to obsess about some textbook model of competitive advantages. You want to find businesses that will compound wealth.


The basic question is always the same. Will customers – in 5, 10, 20, 30 years – happily pay more for the company’s products than it will cost the company to make those products?


It sounds like a hard question. But usually the factors involved are simple and psychological.


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