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Stepan Lavrouk
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Warren Buffett Explains the Difference Between Good and Bad Businesses

A great business does not throw up difficult decisions

June 13, 2019 | About:

A key part of value investing philosophy is viewing yourself as a part owner of a business, rather than just as the holder of some security. This means that you have to put yourself in management’s shoes and consider the problems of a business in a way that an executive or board member would. At the 1998 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder meeting, Warren Buffett (Trades, Portfolio) explained why the best businesses are those in which management does not have to make difficult decisions.

Easy decisions are good decisions

Good businesses are those that give management easy decisions to make. Bad businesses give management hard decisions to make. That is the crux of Buffett’s argument. If you have a high level of confidence that increased capital spending is going to eventually translate into higher earnings, then that is a great business to own. Buffett illustratedthis first case with the example of Coca-Cola (NYSE:KO):

“At Coca-Cola, particularly when new markets come along -- the Chinas of the world, or East Germany or something of the sort, the Coca-Cola company itself would frequently make the investments needed to build up the bottling infrastructure to rapidly capitalize on those markets, the old Soviet Union [for example]. So those are expenditures where you don’t even need to make the calculation, you just know that you’ve got to do it -- you have a wonderful business and you want it to spread worldwide, and you want to capitalize on it to its fullest. You can make a return on investment calculation, but as far as I’m concerned, it's a waste of time because you’re gonna do it anyway, and you know you want to dominate those markets over time.”

Coca-Cola eventually spun off its own bottling facilities to local businesses to cut costs, as it does in many parts of the world. But it had to make the upfront investment in the early 1990s because it could not afford to wait for those businesses to appear. Dominating the new market was too important, and obviously very profitable.

Bad decisions are agony

On the other hand, bad businesses require high levels of capital expenditure just to stay afloat. They might have to spend and spend, and have no idea whether this will lead to increased earnings. Buffett used USAir (merged into American Airlines (NASDAQ:AAL) in 2015), an investment that he considers one of his more significant mistakes, as an example of a bad business:

“Charlie and I sat on USAir and the decisions would come along and it would be a question of ‘Do you buy the Eastern shuttle?’ or whatever it may be. And you’re running out of money, and yet to play the game and to keep the traffic flows moving you just have to continually make these decisions where you spend a hundred million dollars more on some airport, and they’re agony, because again you don’t have any real choice but you also don’t have any real conviction that those choices, or lack of choices, are going to translate into real money later on.”

One scenario is forcing you to spend more and more with no idea whether it will work out in the end, whereas in the other, spending more is a no-brainer.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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