Nine Questions To Help You Identify A High Quality Business

Today there are so many different types of businesses out there that you may feel lost when it comes to finding a great one. I often get asked: “Where do I even start in finding a good business to invest in?” Finding the right type of business can certainly be a challenging activity, but luckily, there are certain fundamental characteristics that can help you narrow your search. These fundamental characteristics belong to high quality businesses that posses “superior economics” and thus “expanding value”.

What this means is that if you have a business that will continue to grow, eventually the market will lift the price of the company’s stock. But what is a quality business that will continue to grow? The answer lies in nine questions that can help you to identify businesses that will consistently expand their value.

#1 Does the business operate in what looks like an‘oligopoly’?

What you want to identify are brand-name products or services that people or businesses are dependent upon. For example, if you go into a convenience store, bar, pharmacy or grocery store, what are the products that absolutely must be sold in order for the establishment to stay in business? Some items you may notice would be Marlboro cigarettes, Budweiser beer, Hershey chocolate, Arm and Hammer baking soda, Tide detergent, Pampers diapers, Colgate toothpaste and Canada Dry Ginger Ale. On the services side, what are the things people and businesses must use every day to perform key functions? Some examples would be credit cards such as Visa, Mastercard or American Express, railways and transportation such as CP Rail, Union Pacific or Tyson Foods and even basic IT infrastructure that businesses use such as Accenture. The idea here is to identify businesses that have deep competitive advantages and control so much of the market that it would be nearly impossible to compete with them.

However, businesses with these kinds of oligopolistic qualities do not mean they have to be huge. Although, scale in general does follow market capitalization, a deep competitive advantage is much deeper and involves utilizing incredible strategy to fortify market positions. This can help explain, for example, how the $12bn Dr. Pepper Snapple Group has its products on the same shelf in the same stores with similar global distribution as the $186bn Coca-Cola or the $220bn Nestle. An understanding of global strategy and a deep analysis of a business's true edge can help make any potential investor identify the most important factors.

#2 Are the earnings of the business solid and trending upwards?

Despite having distinct oligopolistic qualities, the business may still be poorly governed and thus earnings may be inconsistent. What you are looking for here are annual earnings per share (EPS) that have been and continue to be on a consistent uptrend.

#3 Does the business have a healthy balance sheet?

If the business possesses the aforementioned qualities and an EPS uptrend it will most likely be generating a lot of cash and shouldn’t need much long-term debt. Nevertheless, there is such a thing as good debt as this type of long-term debt is acceptable if it is used to acquire another oligopoly type business.

#4 Does the business consistently earn a high rate of return of shareholders’ equity?

Like the examination of a business’s EPS it is also important to identify whether it consistently earns a high rate of return on shareholders equity (ROE). If the ROE is consistently high it is a signal that the business’s management is skilled at making money from the existing business but is also able to profitably use retained earnings to maximize shareholder returns.

#5 Is the business able to retain earnings?

Not all businesses can generate a surplus of earnings in the operation of their business. Instead, most businesses have to spend most of their earnings on just maintaining inventory and capital expenditures. But the few that can use their retained earnings to acquire new businesses or expand their profitable core operations are the ones you are looking for.

#6 Does the business have to spend a lot to maintain current operations?

So what we want are businesses that can grow, that can retain earnings and that don’t have to spend all their retained earnings on maintaining the status quo. Some businesses have such onerous capital budgeting plans that they end up having little or no money left to maximize shareholder returns. For example if a business makes $2 million a year, and retains every cent, but every other year it has to spend $4 million replacing equipment the business would simply be breaking even. The idea here is to find businesses that rarely require replacement of plant and equipment and have products that never go obsolete and thus don’t need ongoing expensive R&D. Using a very simple example, compare a railroad company such as Kansas City Southern to a car manufacturer such as Ford. Once the railroad infrastructure is in place, no major capital expenditures need to be made whereas in the case of Ford, car manufacturing requires innovation and huge capital expenditures to constantly keep up with the consumer so large sums must be spent simply to stay in business.

#7 Is the business able to reinvest retained earnings and how good of a job does management do this?

The final dimension of the retained earnings puzzle relates to how the business uses its retained earnings. What you are looking for here is a management team that consistently employs retained earnings for an additional high return. The business can use retained earnings to expand currently profitable core operations, acquire profitable cash generating businesses or if it cannot employ its retained earnings at above average rates of return, to buy back shares. Regardless of which of the three strategies the management team employs, a history of profitable use of retained earnings, or a reasonable promise of future profitable use is key.

#8 Can the company adjust prices to inflation?

There are some businesses such as coal companies, gold companies and cattle companies that are tied to fixed dollar investments. With such commodity type businesses the costs of production can increase with inflation while the prices the business can charge for its products decrease due to oversupply or great competition. In other words, the simple economic forces of supply and demand within their relative markets can deem these businesses obsolete. You want to avoid these businesses and instead look for businesses with oligopolistic qualities that can increase their prices to keep up with inflation without causing a decline in demand.

#9 Will the market value of the company increase due to the value added by retained earnings?

At the end of the day, if the business you are considering measures up to the last 8 factors, what you want to see and what you most likely will see, is that as the net worth of the business grows, so does the market’s valuation of the business and hence its stock price. This is the exact opposite of being interested in a stock that has been rising due to speculative pressure. Instead, ignore what the stock price has done in the short term because if you have found a high quality business as outlined above, chances are that in the long term, the market will adjust the stock’s price to mirror the true value of the business.