In a couple of my last articles, I've made it clear that while we do not know if now is a good time to buy stocks or not, buying good companies at great prices is always a sensible investment strategy.
But how do you determine which companies are good companies in the current market? How can we tell which businesses will still be around five or ten years from now? Warren Buffett (Trades, Portfolio) issued some advice on this topic back in 1991 as part of a series of lectures at Notre Dame.
Buffett told his audience in 1991 that there are a couple of quick tests investors can use to see how good a business is. The first is to ask, "how long does the management have to think before they decide to raise prices?"
"You're looking at a marvelous business when you look in the mirror and say "mirror, mirror on the wall, how much should I charge for Coke this fall?" [And the mirror replies, "More."] That's a great business. When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, [and say] "just another half cent a yard." Then you get up and they say "We won't pay it." It's just night and day. I mean, if you walk into a drugstore, and you say "I'd like a Hershey bar" and the man says "I don't have any Hershey bars, but I've got this unmarked chocolate bar, and it's a nickel cheaper than a Hershey bar" you just go across the street and buy a Hershey bar. That is a good business. The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business."
The other marker of a good business is how essential the firm's product is to customers (this also has an impact on its ability to raise prices). He used the then highest priced newspaper in the United States, the Daily Racing Form, as an example:
"It sells about 150,000 copies a day, and it has for about 50 years, and it's either $2.00 or $2.25 (they keep raising prices) and it's essential. If you're heading to the racetrack and you've got a choice between betting on your wife's birthday, and Joe's Little Green Sheet, and the Daily Racing Form, if you're a serious racing handicapper, you want The Form. You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it...
It's like selling needles to addicts, basically. It's an essential business. It will be an essential business five or 10 years from now. You have to decide whether horse racing will be around five or 10 years from now, and you have to decide whether there's any way people will get their information about past performances of different horses from different sources. But you've only got about two questions to answer, and if you answer them, you know the business will make a lot of money."
Companies that meet both of these criteria are few and far between, but they do exist. When they are on offer, it often makes sense to load up with a bucket, not a thimble, as the opportunity to buy good businesses at great prices does not come around often.
Disclosure: The author owns shares in Berkshire Hathaway
Read more here:
- 3 Deep-Value Stocks for the Bear Market
- Lessons on Investing From Warren Buffett's 1962 Partnership Letter
- Why Did Warren Buffett Sell Some of Berkshire's Airline Holdings?
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