MONTAG portfolio manager Tom Frisbie, CFA, manages an equity selection process that involves, in part, determining whether a potential stock purchase represents a “good” business. Of course, whether a business is “good” or not is a subjective judgment, or, in other words, in the eye of the beholder. However, several years ago Tom articulated the factors that he uses to determine if a business is “good” or not. We think that those factors are still very relevant today and that the more of them your equity investments feature, the stronger will be your companies’ performance. So we reprint them here. (And Tom would be the first to point out that he has no pride of authorship-these factors have been articulated earlier and better by Warren Buffett and noted Harvard business school professor Michael Porter.)
CHARACTERISTICS OF A SUPERIOR BUSINESS MODEL
- It earns its revenues in cash, not accruals.
- It sells products that are difficult to postpone.
- It sells products that are low in price, making price increases tolerable to the budgets of its customers.
- It sells products to a diversity of customers, none of which has more bargaining power than it does. Companies that sell to governments, government bureaucracies or dominant producers have little pricing power.
- It has differentiated products that give it pricing power; differentiation can be based on technical characteristics or branding.
- It can grow revenues much faster than capital spending; in essence, its new products can be line extensions and come from factories that already support the business.
- Its costs are dominantly variable so that the business can be scaled to changes in revenues.
- It is not unionized.
- Its costs are not dominantly determined by the level of interest rates or changes in the market’s cost of debt or equity capital.
- It is self-funding through internally generated cash flows.
- It is a toll-road on some form of commerce, such as media ratings, essential business information, or dominant payment systems like credit cards.
- Due to branding, high costs of capital for new entrants, or natural barriers to competition (quarries, local newspapers, railroads, cable companies), it is hard for new entrants to become profitable (ever).
- Due to a high degree of complexity in end-products and high cost of capital to new entrants, it would be impractical to foster margin killing competition.