Masters Series: What Makes for a Great Business?

Stansberry Research: Legendary investor Warren Buffett has often said his ideal investment is a wonderful business trading at a fair price.

Many investors are familiar with price-to-earnings ratios, price-to-book values, and other measures of value. But we hear relatively little about what actually makes a great business. Dan, can you describe what makes a great business?

Dan Ferris: Well, great businesses can be defined a number of ways, but most of them share a few common traits.

One of the most important traits is what's known as a durable competitive advantage. Put simply, it's an advantage over the competition that is likely to last for a long time… and often has already lasted for a long time.

In capitalism, when a company is extremely successful, you inevitably get competitors coming in. If a company is making an 80% gross margin, someone will come along and say, "I'm going to undercut them and earn a 70% gross margin." Then someone else comes along and says, "I'm perfectly happy with 60%." Before you know it, it's not 80% anymore… it's 8%.

When a company is able to sustain superior performance over a long period of time, it's a clue there's something special going on… that the company has a tangible advantage in its industry. That's an invaluable trait… and one most of the world's best companies have.

Wal-Mart is so big and efficient, it can do anything any other retailer can do… only much cheaper. ExxonMobil is like that, too. So is UPS. UPS owns an enormous global transportation and logistics network. It's difficult to compete with.

Burlington Northern and other American railroads have an excellent durable competitive advantage. They own thousands of miles of railroad track, and nobody wants anyone to build more railroad track.

Once you get a railroad built through a particular area, chances are folks won't want to allow another to be built there. People don't generally like to have railroads and pipelines in their backyards.

Stansberry Research: A durable competitive advantage. What's another trait?

Ferris: Another important one is thick profit margins. A thick profit margin generally indicates a business is efficient at allocating capital and controlling costs, so more of its revenue can be retained as profit. It also means the business has a built-in buffer of safety… meaning the risk that a drop in revenue will cause an operating loss is much lower.

Obviously, this means some industries are much more likely to produce great businesses than others… But if a company can maintain a relatively thick, stable profit margin compared with other businesses in the same industry, it's another big sign you're on to a great business.

Thick profit margins are universally desirable. Everybody in business would much rather net $0.20 in profit for every $1 of sales than $0.02. When you're able to hold off competition AND make a thick profit margin, that's as good a financial result as a business can ever get.

A third characteristic of a great business is low capital expenditures. This basically equates to being able to employ a relatively small amount of capital and get incrementally more growth out of it.

A great example here is Microsoft. Microsoft didn't need to build a factory to produce its new Windows operating system. It didn't need to build a mine or buy a million trucks or a million planes or anything of the sort. It required just a small capital investment, next to none really. It might have needed to hire a few more people. Therefore, it is able to make a huge return on its investment. That's a great characteristic.

Warren Buffett often gives the examples of Coca-Cola and See's Candies, because they've required little capital to grow… and they earn so much more than when he first invested in them.

Stansberry Research: Most of the companies you've mentioned are big and super well-known. How important is an elite name brand?

Ferris: A recognizable brand that everybody really wants is a big advantage.

Think about the difference between, say, Hershey and any other candy bar…

It's three o'clock in the afternoon, and you feel like having a Hershey bar to get you through the rest of your work day. You walk outside your office, and there's a little store on the corner. You go inside, and see some other brand of chocolate bar, but no Hershey.

Right across the street, there's a 7-Eleven that you know has Hershey bars. I think many, many people would cross the street for the Hershey bar. THAT is a great brand.

When I shave, I use Gillette. There's just no substitute for it. When I sit down for lunch in a restaurant I've never been to, my first question for the server is, "Coke or Pepsi?" If it's Coke, I'm good. If it's Pepsi, I'll have iced tea. At dinner, my first question is, "Do you have Sam Adams?" I hardly ever drink any other beer. I don't think I'm that unusual. People trust certain brands.

That's one of the reasons McDonald's is so successful. You can get exactly the same food at all 30,000 restaurants. It's uncanny when you think about it, how they're able to make all those identical Big Macs all over the world every day.

I could go on, but you get the picture. They could raise the price of Coke, Big Macs, Sam Adams, or Gillette razors by 10% or even 15%, and it wouldn't faze me a bit. That pricing power is one of the primary attributes that makes an elite brand name so valuable as a business.

Of course, it often goes hand in hand with other traits. Coca-Cola is known all over the world. At the same time, it has the world's largest beverage-distribution system… meaning it can sell a lot more of any product than anyone else.

So if you create some new soft-drink product, you can either try to build a distribution system yourself or you can just go to Coke – which has the world's biggest distribution system – and you could conceivably get that product into more people's hands quicker than by any other means.

Stansberry Research: Any other traits common among great businesses?

Ferris: There's one more that's also related to the others… and that's scalability. It's not a coincidence that many of the world's greatest businesses become huge blue-chip companies. A great business can be scaled easily… So given enough time, many of them grow to be large.

It's an advantage in some ways. Obviously, it's a hindrance in others. You can't grow as fast once you're big. But you can still grow. And in general, you can pay for that growth much easier than your smaller competitors can.

Like I mentioned before… Wal-Mart is better at cutting costs and moving large amounts of merchandise for a lower price than anybody else is. ExxonMobil is better at navigating the cycles of the oil and gas industry than anybody else is.

You can go right down the list and say this company is better at this than anybody else is… and it's how it got so enormously big. Wal-Mart, ExxonMobil, Apple, Microsoft… They are some of the biggest companies in the world, and they're all hugely successful.

That's probably the simplest way to see there's something special going on… that they have something other companies don't.

Stansberry Research: Thanks for talking with us, Dan.

Ferris: You're welcome. Take care.