Build a business that Buffett would want to buy
A manifesto for business owners and corporate executives.
JB: I’m still working on part two of my four-part series of essays on social justice in theory and reality. You can read the first essay here, where I introduce the series and try to explain the movement that has dominated politics and society for the last half century. The second in the series will be out soon, I promise. Until then, enjoy this detour into the business world!
Everyone interested in business or investing has heard of Warren Buffett. His company, Berkshire Hathaway, has accumulated like a snowball from 1965, showing no signs of stopping. It owns large stakes in public companies such as Coca-Cola and Apple. It runs one of the world’s best regarded insurance businesses. It owns several private businesses outright, such as See’s Candy and Nebraska Furniture Mart, each of which generate tens of millions of dollars in earnings each year.
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A common misconception of Buffett is that he is an expert at picking stocks. Don’t get me wrong, he has an airtight track record of buying shares in public companies. The difference is that picking stocks is not Buffett’s goal. His goal has always been to purchase outstanding businesses, regardless of whether they happen to be public or private companies. He can buy shares in a public company or attempt to buy a private company outright, but his goal is always the same: buy an excellent business.
I believe that the principles he has used to identify excellent businesses form a valuable treasure trove for people running businesses. Not because I think you should literally want your company to be bought by Buffett’s company. But because it will help you to make your business more excellent. In this post I will lay out these principles and then show you how I have attempted to apply in them with my own company, which I use to publish my books and audiobooks, so read to the end!
Here are the identifying factors of excellent businesses:
Consistently generate high returns on equity. This means that your business’s annual net income after tax is consistently high, relative to its equity (equal to its total assets minus its total liabilities). This is valuable because it shows that your business does not require a large amount of initial capital to make money. Like See’s Candy, which Buffett bought in 1972, your business focuses on the products or services with the highest returns, and eliminates anything that does not generate an adequate return or requires too much capital to sell.
Identify any activity that is not generating a return. Believe it or not, your business is not a charitable concern—it exists to return a profit at the end of each year. You need to take a hard look at your business’s line of products and services and identify the best and worst performers by the metric of profitability. Focus on the best and eliminate the rest, or at least significantly scale down anything that does not generate a return. When Steve Jobs took over Apple in the 1990s, he saved it from bankruptcy by slashing its product line to just four. Yes, four.
Increase intrinsic value by at least 15% each year. Politicians love inflation. If it is gradual and slow, with prices and wages rising in lockstep, then people feel richer when all that has really happened is their money has become less valuable. This is why your business must show a gradual increase in value over time in order to outstrip inflation. This can be measured by an increase in total equity or net income. Buffett prefers to use a discounted cash flow calculation, and wants to see it increase for a business by at least 15% each year.
Be simple enough to explain to a layman in a sentence. This one is more controversial. Buffett freely admitted that this rule prevented him from investing in Google at a very early stage, a mistake that cost him billions in lost value. But it has also driven him to focus on businesses that anyone can understand: See’s Candy make chocolate; GEICO sell car insurance; Coca-Cola make sugared drinks; Fruit of the Loom make t-shirts, and the list goes on. It is less of a hard rule than one tailored to you. Do you understand your own business?
Get rid of any debt as quickly as possible. Buffett does not want to assume responsibility for a company saddled with debt, and it should not be hard to understand how this translates to your business. Getting rid of your debt should be a high priority, to save you from having to pay interest on debt that ends up consuming your business. If it means selling off assets or selling shares in your company to pay it off, then so be it. It is much more relaxing to have a bank account full of cash, without anyone else having a claim on any of it.
I read a fantastic book earlier this year named Buffettology, which explains that Buffett is looking to invest in businesses that model toll booths. This is a business with a consumer monopoly to which everyone must pay money in order to access some prized product or service. With a literal toll booth over a road or bridge, only one company can run it, and you have to pay the attendant a toll to cross over. But you can apply the same principle to find analogues in your own business.
Here are the ways you can identify a toll booth and use the concept yourself:
A toll booth has a firm and stable economic moat. This means that your business will consistently generate some amount of money, like the toll booth over a well-used bridge. Great modern examples include the companies that run stock markets, such as ICE or CBOE. Anyone who buys a stock or an option on these exchanges must—directly or indirectly—pay a small fee to these companies, just like a toll booth. But how does this help you? Here are some options.
Option 1: Sell an “all-weather” product or service. People are always going to need haircuts. People are always going to prize a local newsagent. People are always going to need to buy, sell, or rent houses. These are “all-weather” businesses. They won’t generate huge profits in a short amount of time, but they will generate a consistent return over many years, assuming you can keep up a high quality of service over that time. Consistent being the key here.
Option 2: Sell advertising space that businesses must use. Before the internet boom, local newspapers were a staple of Buffett’s investment strategy. Where one local newspaper dominated readership, every business in that neighbourhood had no choice but to advertise themselves through that newspaper. There was no internet or social media to compete with that newspaper. See how that is the same as a toll booth? It is a consumer monopoly for a local neighbourhood.
Option 3: Sell a frequently used, expiring product that businesses must use. Every car garage in the country uses WD-40. It is simply the best product of its category. Even better for the company that sells WD-40, canisters expire quickly, so customers have to buy a lot of it. When every business needs to use a specific product and needs to consistently renew it on a frequent basis, the company that sells this product is enjoying a consumer monopoly.
That’s a lot of information. In a nutshell, look for companies that emulate the toll booth: everyone has to go through them in order to get something, or in order to make money themselves. I’ve put together some short case studies to help you identify the kind of toll booth companies (with disclaimers where appropriate), and to see if your business is on the right track. For some spice, I’ve also included an anti-example that would fail Buffett’s acquisition test.
Here are the case studies, both good and bad:
Google is a dominant search engine, and all online businesses must consider advertising on its search results pages. Even as it faces criticism for its terrible record on privacy, searchers continue to choose Google over the rest. I prefer DuckDuckGo for my searches, but Google for my pension portfolio (that’s my disclaimer). As a consequence, Google’s business has thrived, year after year, in both good and bad market conditions. Check out its financials here.
Visa and Mastercard both manufacture and maintain credit and debit cards, earning a small fee from every transaction made using their cards. Any bank or other business selling cards to its customers must pay one of these two giants. That’s what we call selling picks and shovels to those looking for gold. Both of these companies enjoy a valuable economic moat as a result, and they are both in my pension portfolio. Here are Visa’s and Mastercard’s financials.
Apple enjoys a consumer monopoly because the people who use its products tend to only want to use their products. I use a MacBook Pro and an iPhone, and I have no intention of deviating in the near term future. I know I’m not alone, and that spells a consistent return for Apple. I dread to think of how much money I’ve paid for Apple products since my first iPod in 2005. Multiply that by millions of happy customers, and you get one of the most successful companies in the world.
Anti-example: Apple wasn’t always a great business. Before Steve Jobs took the helm for a second time in 1997, Apple was on the brink of insolvency. It had extended into dozens of mediocre products, including licensing out its operating system as Microsoft did. Jobs’s remedy? Focus. He reviewed every product they sold, judged them as terrible, and rallied the company to produce the iMac, one great product in a new, much smaller, product line.
Anti-example: Coffee shops are notoriously unprofitableunless they can consistently keep people coming in and paying a premium for better coffee. But since coffee is a commodity product that anyone can create, it is particularly difficult to gain a competitive advantage over other coffee shops in the area. They are interchangeable. Nevertheless, more aspiring entrepreneurs dream of owning a coffee shop than, say, a profitable business like a corner shop or a laundrette.
What about me? I am proud to say, reader, that I am putting my money where my mouth is. My company, Subject Zero Ltd, publishes my books and earns money from royalties. I realised that my company was haemorrhaging money on technical infrastructure that generated no revenue in return. Changing that and “getting real” about the time spent have allowed the company’s finances to turn around.
Here are the major strengths of my company:
Strong and consistent earnings from audiobooks. I quickly realised in my review of my company’s finances that the audiobook versions of my books generate way more royalties than the digital or paper versions of my books, and this trend does not show any signs of stopping. It shouldn’t be terribly surprising—audio content enables readers to more quickly and easily enjoy content. Every day since mid-2017 I have listened to some audiobook or podcast.
Significantly reduced costs. My review revealed that I spent close to 90% of monthly revenue on server costs, and those costs generated zero revenue in and of themselves. Yes, zero. It took me a while to delete all of my resources on AWS, but it will have a high return going forward. I’m angry at myself for burning so much revenue on useless technology. That revenue will keep coming in, though, and I look forward to seeing it grow without being saddled down by high costs.
Once created, books incur no ongoing capital expenditures. Books take a significant investment of time and effort to create. Hiring an editor and cover designer to help polish and sell a book can be expensive. But once that book is finished and published, there are no further ongoing capital expenditures. With print-on-demand being an option to book publishers, there are virtually no costs to selling books online. They continue to earn royalties forever.
No debt, just cash. My company is in this lucky position because my books incur no ongoing capital expenditures. My books and audiobooks continue to sell well online and generate royalty revenues. I don’t think my books would benefit from expensive marketing campaigns. They would benefit from more online attention, which you can get for free, but I am not the kind of person to seek attention. I would prefer that my books grow my reputation in their own time.
A renewed focus. Before this exercise, I made a half-hearted effort to use the company to try finding web development work on the side. I didn’t succeed at extending into that area, and I now see this was a mistake. My company exists to publish and sell my books, and does this well. I should think very carefully before trying to line-extend my company into new areas again. In the meantime, I will keep writing new books.
So, my company generates a high return on equity thanks to its income from book royalties, requiring virtually no ongoing capital expenditure. If people want to read my books, they have to pay me, whether directly or indirectly. That adds up to a strong and durable economic moat. Hopefully the company will start to snowball. But the company is not without weaknesses. In fact, I have identified two major weaknesses that could threaten the company’s fortunes going forward.
These are my company’s two weaknesses:
Total reliance on Amazon, Audible, and Apple Books. If any of these platforms kick off my books, then my company loses its main source of revenue. My books simply do not sell well enough on any other platform. I don’t think this would ever actually happen, unless I decided to be super controversial and get myself cancelled on social media. But it does worry me. Even so, while I would love to find a new way to sell my books, these three are just too good at it!
Writing new books takes time, effort, and capital expenditure. If any one of my books becomes more popular, then my company’s royalty income will increase. But another way to increase royalties is to write new books, and this is no easy task. It takes slightly less than a year for me to properly plan and write a finished book, and I don’t always have the time or energy to write. Don’t get me wrong, I will always love writing new books, but it takes a lot of time and effort!
In conclusion, I think it’s important for anyone running a company to look at their activities and honestly assess which of them are returning income at low cost, and which are not, and then focusing on the former at the expense of the latter. The end result is an asset that, ideally, starts to snowball into a monstrous engine of profit. Remember, the goal of this isn’t necessarily to sell your company, but to turn it into something that any investor would want to have in their hands.
“But what about Starbucks!?” Starbucks have managed to vertically integrate much of their business and purchase prime retail space in big cities, maximising the footfall of customers in their shops. As a bonus, they manage to make their coffee-making process simple and repeatable. That gets people in the door in a way that most coffee shops can’t. Their real estate portfolio requires a huge amount of capital to sustain, eating into their operating profit from selling coffee and cakes.