“The good business is one that earns a high return on capital; the very best business is the one that earns a high return on capital and grows over time… Yet, a good business that does not grow can be a good investment if the investor doesn’t pay too much.” -Warren Buffett (Trades, Portfolio)
What would you pick as the single most significant factor to judge a stock? Most of you may think return on capital. With the help of an economic moat that resists competition, the business is expected to sustain its “unfairly” superior returns over time. Nonetheless, this is far from being sufficient for the company to join the very elite group. The reason is not difficult to understand. If the company finds no internal source of growth to deploy its retained cash, that high rate of return means little to shareholders going forward. In such a case, Warren Buffett (Trades, Portfolio) would put the company in the category of “the good businesses,” but not “the very best businesses,” as described above.
Admittedly, the very best businesses are a rare species. Regardless, the good news is that a good business can lead to a good investment if purchased at the right price. Why? A consistently superior return on capital can be indicative of a highly durable competitive advantage and a favorable market position, both of which add to the predictability of future cash flow. Buffett’s Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) is home to many good businesses, such as utility companies and insurance. Many of them possess few or no secular growth opportunities, but still spit out tons of cash year after year for their parent company to allocate somewhere else for far better returns on reinvestment. Of course, the critical assumption for a good investment here is that investors did not pay too much at the beginning.
Take a look at the two candidates that we think fall into the category of good businesses – United-Guardian Inc. (UG, Financial), which develops cosmetic ingredients and health care products in niche categories, and Ste Marseillaise du Tunnel Prado Carenage (XPAR:SMTPC, Financial), which operates the Prado-Carenage motorway toll tunnel in Marseille. Both companies generated normal free cash returns on assets for the past decade, as displayed below. They both have a strong balance sheet, with plenty of cash so that the real return on (non-cash) assets can be even higher than it appears.
We think that both businesses have been guarded by their respective economic moats – a niche focus (on the business area with only approximately $13 million annual revenue) for the former and a classic “toll-bridge” type of location advantage for the latter. However, both have been “suffering” from the same issue of no growth opportunities with an attractive rate of return. This is why we see the sluggish movement over their top lines (see below) as these companies simply did not retain and reinvest much of their profits to fuel growth.
If such a situation pertaining to the good business persists, shareholders should theoretically harvest a yearly return similar to the earnings yield or free cash flow yield.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Berkshire Hathaway.
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