In his 2007 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders, Warren Buffett (Trades, Portfolio) detailed what characteristics qualify a company as a dream business, using See's Candies as the prototype.
"At See's, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See's sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See's family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
We bought See's for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See's sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth - and somewhat immodest financial growth - of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us."
Simply put, it is the kind of business that can grow even with minimal capital reinvested. In the meantime, it can afford to return almost all earnings to owners.
Admittedly, great businesses like See's are a rare species. We have had the good fortune to land on these three U.K.-listed names below that look promising to us and possess similar characteristics.
Rightmove PLC (LSE:RMV, Financial) operates the U.K.'s number one real estate portal, which aims to makemoving easier (as indicated by the company name) through a simpler and more efficient property marketplace.
Leveraging a classic online classifieds model, Rightmove benefits from the two-sided network effect, which provides a substantial competitive advantage. As illustrated below, the growth of operating cash flow has been roughly in line with the financing cash flow (mainly share repurchases and dividend payout), while the growth of investing cash flow has remained almost flat.
The business managed to gain market share without much reinvestment thanks to its market-dominating platform (with almost 80% of the total traffics in the space) as well as the virtuous cycle, where more listings attract more users, which in turn attracts more paying customers to list on the platform.
We see a similar phenomenon at Bioventix PLC (LSE:BVXP, Financial). The U.K.-based antibody developer takes advantage of its asset-light, royalty-based business model, the high switching cost of its highly specialized products and a tailwind of the aging population to consistently generate super-normal and improving returns on capital. Meanwhile, the business grew its top line at a compounded annual rate of 21% and net profits by 26% over the past five years. As indicated below, Bioventix required nearly no reinvested capital to sustain its operations and expansion.
Israel-based Plus500 Ltd. (LSE:PLUS, Financial) is a financial company providing online trading services in contracts for difference (referred to as "CFD") across more than 2,000 securities and multiple asset classes. As with Bioventix, the business has earned a consistently high return on capital since its initial public offering. Additionally, the company never spent more than 0.7% of its annual sales as capital expenditures due to its asset-light, highly-scalable operations. As implied in the chart below, most of the operating cash flow was returned to shareholders through dividends and share repurchase (when the price is reasonable).
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 Rightmove, Berkshire Hathaway, Bioventix and Plus500.
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