It is pretty clear that Warren Buffett (Trades, Portfolio), the Oracle of Omaha, knows how to pick good businesses. Even though his record of picking investments is not spotless, over the years, he's made a tremendous amount of money from investing in companies that have a wide margin of safety and deep moat.
Finding these businesses is not a science, it is an art. You need to know what you are looking for, and even if you do understand everything about a business, it can still turn on you.
That said, some businesses have better qualities than others, and in a lecture to MBA Students and Undergraduate Students at Notre Dame, Buffett tried to distill down the process of finding the best businesses into two simple questions.
"A couple of fast tests about how good a business is. First question is “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."
So, the first question you need to ask is whether or not clients will be willing to pay more for a product if prices were increased tomorrow. If not, it's more than likely that the business does not have a unique product and it is fairly constrained in what it can do.
"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."
If you are looking for a good business, the first place to start then is by assessing how quickly it can increase prices.
The second question to ask is: How replaceable is the product? If it is something that can be easily replicated, any attempt to increase prices will lead to lower sales. However, if it is the only product of its type, a company can raise prices without having to worry about an exodus of customers.
"I’ll try this on the students later: What’s the highest price of a daily newspaper in the United States? [Pause] [This is what he said to the students later: Most of you are familiar with it. The highest priced daily newspaper in the United States, with any circulation at all, is the Daily Racing Form. 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. The Form has huge profit margins, incidentally. Wider than any other newspaper. They charge what they want to basically. It’s an easy to understand business – so easy to understand."
There are the two questions Buffett asks himself when considering a potential business investment.
"There are products like that, and there are products like sheet steel. And they’re night and day. "
Disclosure: The author owns no stock mentioned.
