What makes a business 'good'?
A short one from us this week (hey – it’s the holidays!). Recently, we have been collaborating with other investment professionals to evaluate investment ideas together. During a post-management call debrief one of the investment managers asked a simple question “Does this company we are evaluating have good business?” This question sparked a lively debate and it also forced me to recall the tenets of a ‘good business’. Below is a list of items that you should look for when evaluating whether a business has sound fundamentals. We hope this is a useful checklist for you when you’re evaluating a stock, a bond, a VC investment, or even your own business/startup!
Moats – Does the business have a competitive advantage that its competitors will find it difficult to replicate. A strong moat will protect the business in the long-run both from competitors and itself. Pat Dorsey, head of Morningstar equity research, likes to use the example of Coke – considering all its missteps (remember New Coke?) over the years, it’s indubitable that its moat (its brand) has kept it thriving for 133 years! Below we’ve gone into detail on a few types of moats, but do read Pat Dorsey’s “The Little Book that Builds Wealth” which does a great job of defining many more.
Network Effect – Despite all the negativity you’ve seen from in the media about Facebook we continue to see daily active users stay steady (actually even climb a bit). Why? For most long-term users, Facebook stores all your memories, photos, info on your friends (ie birthdays) for more than a decade. Facebook has an undeniably strong network effect. How do we know? Look at the amount of posts complaining about Facebook… on Facebook.
High Switching Costs – While Spotify has some serious issues with its business model, one thing it users do face is high-switching costs. There are so many competitors these days, Apple Music, Youtube (yes they now have a music streaming service), Tencent Music etc. But why haven’t we switched? All our playlists are already setup in Spotify…
Other examples of moats: Licenses/regulation, Patents, Economies of scale
Market Size - Is the market the company operates in big enough? As Bob Iger, CEO of Disney, says in his latest book “My former boss Dan Burke once handed me a note that said: Avoid getting into the business of manufacturing trombone oil. You may become the greatest trombone-oil manufacturer in the world, but in the end, the world only consumes a few quarts of trombone oil a year!” A small market size makes it tough for a business to grow to anything significant, even if they capture most of the market share. Be careful about investing in a company that sells winter coats in Singapore.
Pricing Power – A derivative of having a strong moat; can the business increase prices without having much of an effect on customer retention? Is the business a price setter or price taker? Typically this is where commoditized business struggle. Also, beware of how much reliance you put on the ‘brand’ as unless the strength of the brand allows you to raise prices, we’re not sure how useful the brand is over-time.
Operating Leverage – If you’re looking at a business that produces widgets, and the cost to produce the next widget is the same as producing the previous one, this business lacks operating leverage. For a good example of operating leverage - look at the Singapore gaming company Garena (owned by Sea Limited). A large part of its revenues are derived from players making in-game purchases (virtual skins, currency etc). The incremental cost to Garena for each purchase? $0. Some might argue that strong operating leverage is the key that turns a “good business” into a “great business.”
Management – We would be remiss if we didn’t mention this one, but in full honesty we find evaluating management quite a tough thing to do. No doubt you want a company with leaders of high-integrity, openness, and intelligence. However this is a bit hard to ascertain in advance, and it’s only retrospectively that you come to know if the CEO/management team were truly amazing (read “The Halo Effect” for more on this topic). Also, great management cannot overrule a business with poor fundamentals. As Warren Buffet puts it, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
While this is not an exhaustive list, and there are plenty of exemptions to the above – we hope it gives you some sense of how to think about the next business you evaluate. Some businesses will have none of these characteristics, some will have a few, but when you find one that has them all – well then you’ve got yourself a winner.
Happy Holidays and Happy Investing!
(Note – none of the company references above should be construed as investment advice. Examples are used for discussion purposes only).