Friday, October 16, 2009

Good Businesses to Own

There are businesses and there are businesses. Some companies just cannot generate good enough returns for shareholders not because management sucks or there’s too much competition. It’s the business model that’s flawed.

Usually, it’s the high capex ie very high investment needed to buy new equipment to compete. It’s so high that all the money made from good times is not enough to pay for the equipment. And these companies need new equipment to compete in the next cycle.

We all know these industries: airlines, semiconductors, shipping, heavy industries etc.

Then there are these wonderful businesses that keep churning out cash without the need to invest a lot. And the best things is people just cannot stop buying their products bcos it’s a necessity or they are tied down by other factors to buy.

One good example is actually tobacco companies. As Warren Buffett puts it: it costs a penny to make, you sell at a dollar or more, and people just keep coming back for more. And you don’t need new investments. Perhaps just 15 tobacco factories can supply enough sticks for the whole global population of smokers (my guess). Well there’s the moral issue of course…

To summarize, here are some factors that good businesses have

1. Recurring revenue stream – usually coming from

- razor and blade model (printers, games, ipod and itunes)
- necessity item (toiletries, food and drinks)
- contract/license agreement (anti-virus, telcos, utilities)
- consumables (medical supplies, office supplies)

2. Low capex needs

3. Competition is not severe - usually due to

- limited no. of competitors
- dominant market share

4. Strong barrier to entry or moat (branding, technological edge, market share)

5. Pricing Power – related to

- level of competition and market share
- position in Porter forces

6. Growth Potential

We shall talk about some of these factors and companies with superb business models in the next few posts

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