When someone is asked to give examples of “great businesses”, the names that typically come to mind are well-known consumer brands such as Apple, McDonalds, or Amazon. Clearly there is something about these businesses that make people think they are great. At Baskin Wealth Management, we strive first and foremost to invest in great businesses, but we need to understand what a great business is to begin with! What characteristics should a business possess to make it a great business? As usual, a good place to start is the words of Warren Buffett:
“A truly great business must have an enduring moat that protects excellent returns on invested capital. A formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with Roman Candles, companies whose moats proved illusory and were soon crossed”. He further notes that “It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.” 2007 Berkshire Hathaway Annual Report
It is usually not too difficult to identify a great business and most people understand the value of a strong brand combined with a unique and differentiated product. At Baskin, we maintain a list of companies that we think are great, and follow them actively. For these businesses, our job as an investor is to evaluate both the capital allocation decisions of the management and especially, the company valuation. (Not all great businesses are great investments; we must avoid paying too much, even for a great company). By definition, a great business generates more cash than the business needs to run itself. Does the management then return the cash to the shareholders through buybacks and dividends, keep it on the balance sheet, or make acquisitions? We recently studied a data analytics firm that I would consider to be a great business. It collected and sold a wide collection of research and industry datasets that are must-haves for companies and governments to conduct strategic planning. In the end, we decided not to invest because we felt the management was spending too much on expensive acquisitions; in other words, poor capital allocation.
Obviously the vast majority of businesses are not great. As Buffett noted, many businesses appear at face value to be great businesses but upon closer examination turn out not to be. Take branding for example. Although most non-commodity businesses have some element of branding, it can be difficult to evaluate the true long-term value of the brand. A good example is Newell Brands, which makes well-known consumer products such as Elmer’s Glue and Bicycle playing cards. As consumers shifted more of their shopping online, Newell (and sadly, its shareholders) discovered that its previous sales had relied more on favorable placement at Walmart than on its brand names, and sales fell. Newell’s stock price is currently down 50% from its peak in March 2017 as the market revalued Newell from a safe, dividend-paying, consumer-staples stock to a declining manufacturer of retail products. The brand was not strong, and in the end, there was no moat at all.
Other businesses have reasonably durable franchises with healthy returns on invested capital, but are capital-intensive. This means that that a large portion of the cash flow generated each year needs to be reinvested in the business. Companies like CN Rail or Walmart would fall into this category. We don’t mind owning these businesses if they are available at reasonable prices given their growth trajectory, but we recognize them as good, but not great.
One example of a great business we like is Moody’s, one of the most dominant and influential companies you might never have heard of. Moody’s provides bond rating services for governments and companies. You can think of Moody’s ratings as a credit score for companies. Most bond investors typically are looking for stable income, as opposed to the potential for their investment to double in value. For these potential bond buyers, it is far more important to know the probability that the issuer will go bankrupt as opposed to the growth opportunities of the business. Moody’s ratings simply make it easier to evaluate the riskiness of the bonds.
Imagine that GM wants to sell some bonds to raise money and build a new plant. GM will pay Moody’s to “rate” their bond, and Moody’s will analyze that bond’s riskiness by looking at things like GM’s competitive prospects, GM’s pension liabilities, the cyclicality of the car business, etc. Moody’s will then sum up all of its research into a rating. The ratings go from AAA for the lowest risk, down to C for companies in default.
Most importantly, Moody’s rating determines the rate of interest GM will pay on that bond. Most bond investors do not particularly care which bond they are buying, as long as it provides them with the income that they need. When a banker sells the bond to investors, the investors can simply look at the credit rating and compare it to the interest they get on similarly rated (i.e. similarly risky) bonds.
Moody’s ratings business represents around 2/3s of its total revenue. Moody’s also charges investors for access to its underlying research to support the ratings and provides expert advice to companies for how best to minimize their risk. This represents the remaining 1/3 of the business.
Moody’s has all the hallmarks of a great business. Rating bonds is a capital-light business. All you need is some smart employees. There is no need for capital-intensive things like factories, plants, trucks, stores, or inventory, all of which cost money. Three companies (Moody’s, S&P, and Fitch) have a combined 95% global market share in credit ratings, so it is not surprising that there is little price competition. The “Big 3” are the only companies with enough reputation to influence the cost of interest paid by issuers. No company will switch to a 3rd party bond agency that no one has heard of simply to save a few thousand dollars, while risking the sale of their entire bond issue. What’s more, most bonds are typically rated by two, if not all three of the Big 3 to provide investors with increased assurance of the quality of the bond. There is little competition as long as Moody’s continues to do its job well. Credit markets and bond issuance are huge world-wide businesses that are not going away. As long as investors place their faith in the Moody’s stamp of approval, Moody’s will continue to be highly profitable.