One of the biggest problems investors face on a daily basis is finding good businesses.
Finding good businesses that have the power to stand the test of time is a challenging process.
There are so many things to consider when analyzing these companies. The more time and effort you spend on dissecting a particular opportunity, the higher the chances are that you will miss something essential or rush the process.
What's more, there's no guarantee that you will find a good company. Even if it looks like an operation based on past figures, the future may be very different from the past. Of all the public companies in the world today, there are just a handful of outstanding businesses that can yield impressive returns for investors for decades to come.
Nevertheless, a great place to start looking for good businesses is the capital intensity. As is the case with many parts of investing, there are lots of different figures to consider on this point. However, as a rough guide, companies that require a lot of capital spending every year just to remain relevant can often be bad investments. Some examples include telecom stocks and cyclical businesses such as steel companies. These businesses have to reinvest and virtually all of their profits and cash flow back into operation to maintain output and offset depreciation of capital equipment.
In times of market excess, these companies can generate good profits. For example, steel companis outperform when steel prices rise to cyclical highs. However, this doesn't tend to last long. Higher prices draw out the competition, which leads to higher output levels, more supply and falling prices.
That's not to say that investors cannot make money with these companies. It is possible, but it requires accurate market timing. For example, the European telecoms market, which is much more competitive than the market in the United States, seems to be in a constant price war. That's great news for consumers, but from an investment perspective, many European telecoms have been dead money for decades.
In a lecture to students of Notre Dame in 1991, Warren Buffett (Trades, Portfolio) tried to make this principle clear with a comparison between two companies. The first was a newspaper business run by Lord Thompson, and the second was American Telephone and Telegraph Company. Thompson's business controlled just 5% of the newspaper market in the United States. Meanwhile, American Telephone was the country's largest telecoms business.
However, American Telephone's big problem was its capital requirements. As Buffett explained, the company had to spend $50 billion to increase earnings from $2.2 billion to $5.6 billion:
"So, they got more money, but you can get more money from a savings account if you keep adding money to it every year. The progress in earnings that the telephone company made was only achievable because they kept on shoving more money into the savings account and the truth was, under the conditions of the '70s, they were not getting paid commensurate with the amount of money that they had to shove into the pot, whereas Lord Thompson, once he bought the paper in Council Bluffs, never put another dime in. They just mailed money every year.
One is a marvelous, absolutely sensational business, the other one is a terrible business. If you have a choice between going to work for a wonderful business that is not capital intensive, and one that is capital intensive, I suggest that you look at the one that is not capital intensive. I took 25 years to figure that out, incidentally."
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Some Thoughts on Warren Buffett's Early Investments in Western Insurance Services
- Charlie Munger's Thoughts on How to Value Wesco Financial From 2009
- The Difference Between Warren Buffett and Berkshire Hathaway​
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