Category Archives: Buy Good Businesses

Great quote from Tom Murphy provides an investing template of what to look for

There are not many great businesses that come along in a lifetime. In 1954, television was just starting. People were losing a lot of money in the business, but it was about to explode. Because of the limited availability of licenses, there was limited competition, and so it exploded over the next thirty or forty years. I was very fortunate to be in broadcasting. The business is not capital intensive, nor is it labor intensive. There was a little government involvement but never any price controls. In the last forty or fifty years, broadcasting has been one of the great businesses of this nation. It’s less so now because of synchronous satellite, cable competition, and things like that, but it’s still a very good business.

Tom Murphy

(read entire article; quote on page 4)

Checklist for thinking about great businesses

  1. they are scarce
  2. clear and long runway of growth
  3. limited competition
  4. not capital or labor intensive
  5. minimal government involvement
  6. [a major plus to have a great manager like Tom Murphy]

It is a powerful idea that finding just one business like this and having the courage of your convictions along with patience can produce wealth.

“In the long run, everything is a toaster” – Nokia’s Cautionary Tale

Value investing guru and competitive strategy expert Bruce Greenwald of Columbia University has said that, “In the long run, everything is a toaster.” It is his own pithy way of summarizing the brutal realities of creative destruction and operating or investing in a business without a competitive advantage, or as Buffett famously calls it a “moat”.

Although this lesson has been learned – and re-learned – many times, Nokia once again reminds us that we neglect it at our own peril.

Today’s Wall Street Journal reports that Nokia’s CEO Stephen Elop has revealed his plan for turning around the ailing company.

“Nokia, our platform is burning,” Mr. Elop writes in the memo, reviewed by The Wall Street Journal. “It will be a huge effort to transform our company,” he adds.

Some believe that Nokia will now adopt Google’s Android platform.

It was only a few years ago that that the business press and investors were enamored with Nokia’s dominant position in the global mobile phone market. It enjoyed growing market share, nimble design and distribution resources, and a leading and growing presence in emerging markets.

What Nokia did not have was a moat.

Can they turn the company around? Maybe. But it will be very tough sledding given the prevailing competitive market.

The takeaway: add this lesson to your investing checklist – if you haven’t already – and resolve to use it as one of your fundamental filters.

The Mark of a Good Business: High Returns on Capital (Part 3)

Joel Greenblatt’s Magic Formula looks for good companies that are available at a cheap price. To determine if a business is cheap, Greenblatt looks at the company’s earnings yield, which he calculates by dividing a company’s earnings before interest and taxes (EBIT) by the company’s enterprise value.

To determine if a prospective investment is a good business, Greenblatt looks at the company’s return on invested capital, which is very similar to the general approach taken by Buffett. However, the way Greenblatt calculates return on capital is different from Buffett. Greenblatt uses the ratio of EBIT to tangible capital employed.

Greenblatt uses EBIT instead of GAAP earnings so businesses with different tax rates and capital structures can be more easily and rationally compared. When calculating EBIT for the purpose of screening for Magic Formula stocks, Greenblatt makes the assumption that depreciation and amortization are equal to capital expenditures. This is done to simplify the calculations.

However, if you’re doing a more thorough analysis and not doing formula investing, it’s more accurate in lieu of EBIT to use the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) less maintenance capital expenditures. This approach gives a more accurate view of a business’s free cash flow and, by subtracting only maintenance capex, you can get a better look at the core business without taking into account capital that is being reinvested in the business for growth.

When looking at the Magic Formula, it is important to keep in mind that it is attempting to normalize different businesses so they can be compared on a level playing field. That way you can more clearly see which ones have superior economics, without the distortions that can come from the level of reinvestment in the business and the capital structure of the business.

Now let’s consider the denominator in Greenblatt’s equation for return on capital. As we saw in part 2 of this series, Buffett uses average equity employed by a business less goodwill and intangible assets as a proxy for the amount of capital the business is using. Goodwill and intangible assets are eliminated from the equation because, unless a business is going to grow in the future through acquisitions, the business will not need to pay a premium to reinvest earnings in order to grow organically.

Greenblatt goes farther than Buffett and only includes net working capital – current assets minus current liabilities – plus net fixed assets, which is called tangible capital employed. Greenblatt’s rational for using net working capital is that current liabilities functions as a kind of interest-free loan that reduces dollar for dollar the amount of capital needed to fund current assets. In addition to net working capital, he adds fixed assets because these are the long-term assets directly involved operationally in the generation of earnings and this is the area that will require additional capital to grow the business. It makes sense to see how productively these assets have been utilized on an historical basis.

I believe he leaves other long-term assets out of the equation not because they aren’t important in analyzing a business, but in order to again facilitate the comparison of different businesses so as to find those that are using their capital most productively.

For purposes of screening for Magic Formula stocks, based on the data provided by Greenblatt, this approach appears to successfully select cheap, good companies whose stocks outperform. Those doing active, focused investing will want to use this screen as a starting point for their own in-depth research.

All the tools we have looked at in this series are useful and should be part of your analytical toolkit. As I have stated before, no metric or ratio is a substitute for deeply understanding a business which only comes with thorough analysis and, typically, a good deal of work.

The Mark of a Good Business: High Returns on Capital (Part 2)

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett 1992 Berkshire Hathaway Shareholder Letter

Last week, I wrote a post that looked at return on incremental equity. The post explained a way to measure return on incremental equity over a multi-year period. It also considered how, in a stable business with a durable competitive advantage, the return on incremental equity and can be used, in conjunction with the rate of reinvestment, to predict the growth in earnings.

Today, I am writing about another tool used by Buffett to measure the returns on an investment: return on average tangible net worth.

Beginning with the 2003 Berkshire Hathaway letter to shareholders, Buffett began providing a simplified balance sheet of the manufacturing, service and retailing operations segment, a widely diversified group which includes building products, carpet, apparel, furniture, retail, flight training, fractional jet ownership and distribution.

Buffett breaks out the four broad segments of Berkshire – insurance, utilities, finance, and manufacturing, service and retailing operations – because they each have different economics which are harder to understand if considered as one undifferentiated mass. This is obviously useful to remember when analyzing a business with two or more disparate operating segments.

When he reports on the results of the manufacturing, service and retailing operations segment, Buffett focuses on the return earned on average tangible net worth, which for example in 2003, was in Buffett’s words “a hefty” 20.7%.

To calculate tangible net worth, take the equity on the balance sheet and subtract goodwill and other intangible assets. Buffett averages the tangible net worth that is on the books at the beginning and end of the year so as not to upwardly bias the return if the earnings were in part the result of a large injection of capital into the segment during the year.

On average, the segment enjoys very strong returns on average tangible net worth, typically in the low 20’s. This is highly meaningful because it not only shows the excellent economics of these businesses, but also it shows the returns that can be expected from additional capital that is invested into these businesses.

Here is the simplified balance sheet for the years since Buffett began providing it along with the calculations.

Here are some additional observations.

Buffett also provides the returns on Berkshire’s average carrying value. This is the same calculation as return on average tangible net worth without subtracting goodwill. Berkshire had to pay a substantial premium over book value to purchase these businesses given their excellent economics. Over the long-term, the return on incremental equity will be the major determinant of Berkshire’s returns on these investments as the retained earnings become an ever larger portion on the capital employed. As an investor, you want to pay close attention to both the premium you pay to buy a great business and the returns on incremental capital.

Omitting goodwill and intangible assets from the equation is appropriate because Berkshire will not need to pay a premium on incremental capital employed in the existing businesses. Berkshire does, however, need to pay a premium going forward to acquire businesses to add to this segment. This is evident from the goodwill and intangible assets line item which has grown from $8.4 billion in 2003 to $16.5 billion in 2009. Overall, to put that in context, Buffett invested an additional $15 billion in that segment over the same time period.

In analyzing an investment, you want to consider whether future growth will come from acquisitions, in which case you can expect additional goodwill, or organic investment, in which case the returns on tangible net worth would be a more appropriate metric.

Unfortunately, from the standpoint of providing opportunities for Berkshire to deploy capital going forward, some of Berkshire best businesses, which are found in this segment, are both small in scale as compared to Berkshire as a whole and require very little incremental capital.

Finally, it is fairly clear that this segment’s earning power has been materially impacted by the recession. If it is able to return to pre-recession levels, this group should earn net income of approximately $3 billion.

The Mark of a Good Business: High Returns on Capital

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

A good business is one that can earn very high returns on capital. Rarely can such a business invest all of its capital back into the business. One way to find companies that can is to look for companies that have grown book value at a high rate on a per share basis.

A business can still be a good investment if it can’t reinvest all of its earnings back into the business. An example is American Express. Prior to the 2008 economic crisis, Amex was earning over 30% on equity but was only reinvesting about a third of its earnings back into the business. The remaining two-thirds were paid out in the form of dividends and share repurchases.

There are numerous ways to measure return on invested capital. None of them is perfect. Any of the various metrics and ratios investors use to analyze a business are abstractions and, as such, typically tend to oversimplify the economic reality of the business. They are short-cuts we use to point us in the right direction so we can spend our precious time researching businesses that offer the most opportunity.

Return on Incremental Equity

I like to look at the total amount of equity that has been added to a business over the past decade and then calculate the return on that additional investment. This approach also allows me to calculate what percentage of the company’s earnings was reinvested, which in turn is useful in forecasting the future growth in earnings.

I typically use Value Line when I do this because the layout is very conducive to this type of analysis. It is one reason why investors like Buffett, Munger and Li Lu like Value Line.

It is useful here to remember Buffett’s reminder that it is not necessarily a cause for celebration if a business grows its earnings year after year. The same thing happens to a savings account if you add more capital each year, which does not make a savings account a good investment. It’s the return on this additional capital that determines whether something is a good investment or not.

To illustrate, let’s look at Johnson & Johnson (JNJ). In 2000, JNJ had shareholders’ equity of $18.8 billion. At the end of 2009, its shareholders’ equity had grown to $50.6 billion. We can calculate that, since 2000, JNJ invested $31.8 billion back into the business.

During that same time, earnings grew $8.1 billion, from $4.8 billion in 2000 to $12.9 billion in 2009.

By dividing the additional earnings of $8.1 billion by the additional $31.8 billion in capital, we can see that JNJ earned a return of 25.5% on its investment, which is very good.

It is also useful to look at what percentage of its total net earnings JNJ reinvested back into the business. The reason is that this is suggestive of how much of its future earnings JNJ is likely to reinvest. By multiplying the rate of reinvestment by the return on that investment, we can then calculate an expected growth rate for earnings.

Since 2000 through 2009, JNJ earned a total net profit of $89.7 billion. Since we already know that JNJ reinvested $31.8 billion over that same time period, we can calculate that JNJ’s rate of reinvestment is 35.5%.

If JNJ can continue to earn 25.5% on equity and reinvest 35.5% of its earnings, earnings should grow at about 9% (.255 x .355).

Keep in mind that this does not include dividends or share repurchases. The latter would cause earnings per share to grow at a faster rate. Also, it does not include an analysis of where JNJ is selling in relation to its intrinsic value which could have a material impact on the expected total return. Finally, this type of analysis works best with a stable business that enjoys durable competitive advantages, such as JNJ.

Another example is Southwest Airlines which is a successful airline that operates in the highly competitive and capital intensive airline industry. Between 2000 and 2009, Southwest’s shareholders’ equity increased by $2 billion. Earnings were $140 million in 2009 compared to $625 million in 2000 and have generally bobbed around over that time period. The return on that additional $2 billion has been relatively poor.

Calculating the return on incremental equity over a long-period of time should prove a useful tool in your analysis of prospective investments. Coupled with the rate of reinvestment, it can also allow you to get an idea of how fast a company can be expected to grow its earnings.

You can also use this approach to invert an expected rate of earnings growth to examine what combination of ROE and rate of reinvestment will be required to produce it.

In succeeding related posts, I’ll look at Buffett’s use of return on average tangible net worth and Greenblatt’s use of return on tangible capital employed to determine whether a business is good.

Another Reason Why Investing in a Good Business Makes Sense

Value investing does not always work. Put more precisely, there are periods of poor performance and underperformance. As Joel Greenblatt has pointed out, if it wasn’t this way, everyone would do it. The good news is that, in the long-term, value investing consistently delivers satisfactory investing returns.

What is required is the patience to wait until the market recognizes the mispricing that you uncovered and re-prices a stock to reflect its intrinsic value. Sometimes the market recognizes this quickly, but frequently, it takes several years for this to happen.

This is one important reason why investing in good businesses makes sense. With a good business, time is on your side. There is less risk of the business losing value, and over time many good businesses grow in value so you get a double dip: the price increases to intrinsic value and intrinsic value grows. With a lousy business, time is your enemy as you face the risk that the business will deteriorate or burn through its liquid assets and lose value.

Here a useful list of characteristics of a good business from value investor Richard Pzena. The list can be used as a checklist when analyzing and thinking about an investment.

Good Business

High Barriers to Entry

Brand Name

High ROIC

High FCF

Loyal Customers

Growth Opportunity

Responsible Management Team

Pricing Power

Strong Balance Sheet

Low Capex Requirements

High-return Reinvestment Opportunities

Commodity Inputs – suppliers have low power

Bad Business

Obsolete technology – newspapers

Money Loser

No Strategic Vision

Legacy Costs – high cost producer

A Commodity Product

Poor Corporate Governance

Heavy Regulation

Prone to litigation

High Maintenance CapEx Requirements

Powerful Evidence: Companies with High Returns on Equity Outperform the Market

Over the weekend, I read a book entitled Buffett and Beyond by Dr. J.B. Farwell, who is both an investor and professor of finance. The book presents compelling evidence that stocks of companies with high returns on equity materially outperform the market.

Buffett has been a longtime proponent of investing in these types of companies, which make up the bulk of Berkshire’s portfolio. Also, Joel Greenblatt has presented research which shows that cheap stocks (as measured by the ratio of EBIT/Enterprise Value) with a high return on invested capital outperform the market by a large margin over the long-term. Greenblatt’s approach has been popularized as the “magic formula”.

Buffett and Beyond chronicles Dr. Farwell’s journey as an investor and how he came to focus on stocks of companies that earn a consistently high return on equity.

In order to compare different companies, Farwell normalizes earnings in his calculations by omitting non-recurring items in the income statement and certain non-cash items that would affect a company’s equity, such as a large write-off of a future pension liability. He calls these adjustments the Clean Surplus Accounting Return on Equity. (See the book for exact details.)

The Test

Dr. Farwell tested his ideas by comparing the performance of the eight stocks in the Dow 30 with the performance of the entire DOW 30 and the S&P 500.

Here is his methodology.

“The Portfolio of 8 Dow stocks for any one year was selected by taking the 8 Dow stocks with the highest ROEs for the previous year. Fourth quarter of the previous year was comprised of estimated earnings and dividends, as these numbers are not known with absolute certainty on January 1st.

The 1987 portfolio consisted of the eight stocks out of the Dow 30 with the highest ROEs of 1986.

The calculations were performed on the first day of the year. Thus on January 1st of 1987, the 1986 ROEs were calculated. The eight stocks with the highest ROEs became the 1987 portfolio.

All eight stocks were held for the entire year.”

The Results from 1987 to 2002 – Average Returns

Dow 30 – 13.50% ($100,000 becomes $658,012)

S&P500 – 12.35% ($100,000 becomes $522,651)

DOW TOP 8 18.74% ($100,000 becomes $1,286,085)

Did Farwell Find a Correlation Between the ROE’s and Returns of Stocks?

Dows 30 (average ROE from 1987-2002)

ROE – 14.00%

Total Returns – 13.50%

Dow 8 Stock Portfolio (average ROE from 1987-2002)

ROE – 22.00%

Total Returns – 18.74%

Farwell’s data show a high correlation between a stock’s return on equity and its total return. Keep in mind that the ROE calculations were done using Farwell’s Clean Accounting method.

These are the types of stocks that are included in my watch list. I will add to the watch list each week. The watch list will continue to focus on stocks that have averaged a return on equity of 18-20% over the past 10 years.

Overtime, we can expect Mr. Market to offer shares of some of these companies at compelling bargains. One key to exploit these opportunities is to keep regular tabs on your watch list so you’re not sleeping when opportunity knocks. You will also need to do your own valuation homework so you have the conviction to pull the trigger when the time comes.

Glenn Greenberg & The Importance of Clarity in Valuing a Business

I received a lot of positive feedback on my two-part article on Glenn Greenberg. It is clear that Greenberg is a very talented investor, not in a flashy way but in a way similar to Buffett. They both have a knack for getting to the core issue and for being able to explain a complex reality in a way that anyone can understand.

One of the parts of Greenberg’s talk that most impressed me was where he talks about dropping the use of discounted cash flows when analyzing and valuing businesses.

Investing is about trying to predict what will happen in the future. Our ability to do this is very limited. The future of most businesses is highly uncertain, because they operate without a durable competitive advantage and are therefore bounced about and pummeled by the waves of relentless competition and creative destruction.

On the other hand, there are a select few businesses where you can make meaningful predictions about where they will be in ten years. You are able to see that the conditions that led to their success over the past ten or twenty years – or, in rare cases, one hundred years – are likely to remain in place for the next ten or twenty years.

All this leads me to back to Greenberg saying that, in lieu of doing discounted cash flows, he feels the most important elements in valuing a business are to have a very clear view of why a company is a good business and a very clear view of where the business will be in a few years. The problem with cranking out discounted cash flows is that they create the impression of false precision – that we can actually look into the future and plainly see a company’s free cash flows for the next decade or more.

Greenberg prefers to spend his time and energy on what really matters and what is doable. Remember that there are things that are important and knowable and there are things that are important and unknowable. A company’s stream of cash flows over the next ten or twenty years is very important but for most businesses falls into the column of unknowable.

If you don’t get the part right about whether it’s a good business and where it will be in a few years, the investment most likely won’t work out as planned.

In my judgment, it is not that discounted cash flows per se are flawed; it is, rather, how they are often used – or misused.

Many successful investors use them. The great ones are well aware of their limitations. I believe they are useful to the degree that they make you think about the issues that will drive future cash flows, which brings us right back to Greenberg’s two fundamental questions.

Notice too that Greenberg says he wants to arrive at a “very clear” conclusion. He sets the bar high. This reminds me of when Buffett and Munger were asked at the 1996 Berkshire Hathaway shareholder meeting why they did not buy shares of Pfizer or Johnson & Johnson, seeing that both had a long-term track record pretty much equal to that of Coca-Cola. Munger answered that he and Buffett thought they understood Pfizer and Johnson & Johnson, but they knew they understood Coca-Cola. (1)

They simply decided to invest where they had greater clarity.

Finally, with regards to having a clear idea of where the business will be in a five to ten years, few businesses offer – or offered, when Buffett made his investments – better clarity than Geico and Coca-Cola. It is no surprise that Buffett singled these two out. My suggestion is that you use these two companies as a measuring stick when thinking about the competitive advantages and growth prospects of your potential investments.

Go back and read Buffett’s article on Geico, “The Security I Like Best”. Buffett lays out the growth prospects for Geico in simple, crystal-clear terms. Can you do that for each of your investments?

The same can be said for Buffett’s investment in Coca-Cola. Even after more than a hundred years of superlative growth and execution, they control only around 3% of world-wide consumption of beverages. You don’t need a computer model to see that there is still plenty of runway ahead.

The bottom line is to emphasize thinking and, if you can’t figure it out, move on. There are plenty of other fish in the sea. Cast your lot with one where you are certain and the odds are stacked heavily in your favor.

(1) Berkshire Hathaway annual meeting, 1996, Outstanding Investor Digest, August 8, 1996 edition.

The Ability to Reinvest Capital: The Mark of Investments that Generate Wealth

Markel Corporation, which has a long-term record of compounding capital at a high rate of return under the investment leadership of Tom Gayner and Steve Markel, has a four part equity investment philosophy. They seek, “To invest: 1) in common equity of profitable businesses with good returns on capital, 2) with honest and talented management teams, 3) with reinvestment opportunities and capital discipline, 4) at fair prices.”

I want to focus today on part 3 of Markel’s philosophy. Businesses that can reinvest their capital at high rates of return can generate tremendous wealth over time. They’re the mathematical equivalent of finding a savings account that pays 15-20% interest where you can reinvest your earnings at that same high rate of return for the next ten to twenty years.

Many otherwise very good businesses that throw off a lot of cash – See’s Candies, Google, Microsoft, etc. – reach a point where they are not able to find places to allocate their capital at a high rate of return. For See’s, it was the inability to expand the concept much beyond its core base in California, where it enjoys unusually strong share of mind built up over decades of superior execution. For businesses like Google and Microsoft, their core businesses throw off far more cash than is needed in those business units, and their managements have yet to find an answer for their growing cash balances.

This is less of a problem if you control the business, because you can take the excess cash and intelligently redeploy it. This is precisely what Buffett did with the excess earnings of See’s. With partial ownership of public companies, you are at the mercy of management’s capital allocation decisions. This is another reason to carefully evaluate the management team of a potential investment.

One of the best examples of a business with reinvestment opportunities I’ve come across is Buffett’s example of Thompson Newspapers from a speech Buffett gave at the University of Notre Dame in 1991.

Thomson Newspapers, which most of you have probably never heard of, actually owns about 5% of the newspapers in the United States. But they’re all small ones. And, as I said, it has no MBAs, no stock options – still doesn’t – and it made its owner, Lord Thompson. He wasn’t Lord Thompson when he started – he started with 1,500 bucks in North Bay, Ontario buying a little radio station but, when he got to be one of the five richest men, he became Lord Thompson. I met him one time in England as a matter of fact, in 1972, and went up to see him. He’d never heard of me, but he was a very important guy. (I’d heard of him!)

I said, “Lord Thompson, you own the newspaper in Council Bluffs, Iowa. Council Bluffs is right across the river from Omaha, where I live, four or five miles from my house. I said, “Lord Thompson, You own the Council Bluffs [Daily Nonpareil?]. I don’t suppose you’d ever think of selling it?” He said “I wouldn’t think of it.”

Lord Thompson, once he bought the paper in Council Bluffs, never put another dime in. They just mailed money every year. And as they got more money, he bought more newspapers. And, in fact, he said it was going to say on his tombstone that he bought newspapers in order to make more money in order to buy more newspapers [and so on].

So, where do you find businesses like that? The answer lies in 1) knowing what you’re looking for, 2) having a great search strategy, and 3) working that strategy hard on a consistent basis.

One type of business that has ample reinvestment options at high rates of return is an insurance company run by a great capital allocator, such as Berkshire Hathaway (Warren Buffett), Fairfax Financial (Prem Watsa), Markel (Tom Gayner), or Greenlight Capital Re (David Einhorn). These businesses have both a go-anywhere investment philosophy coupled with a disciplined investment process.

Very few businesses can continue to allocate capital the way these companies can. Moreover, because many CEO’s lack the skill to allocate capital outside their core business, moving beyond their circle of competency may actually destroy value.

The takeaway is to learn to identify these types of businesses and to consciously look for them as you execute your search strategy. You don’t need many of these to get rich.

Opportunity Cost: Buffett & Munger’s Powerful Investing Filter

In the past year there has been a lot of discussion within the value investing community about the use of checklists. The idea has been around for awhile. For example, Poor Charlies’s Almanac, which is a compendium of Munger’s teachings and speeches, contains a copy of Munger’s investing checklist. Munger got the idea from pilots who religiously use checklists to avoid errors.

Also, for years Buffett and Munger have discussed their basic investing filters or checklist:

  1. Is it a good business?
  2. Does it have a durable competitive advantage?
  3. Does it have capable, honest management?
  4. Is it available at a good price?

The idea of investing checklists took on renewed interest as a result of the recent financial crisis as bloodied investors did post-mortems on their dismal performance and searched for tools and insights that might help them do better going forward. One source of insight was an article by Atul Gawande in The New Yorker, “The Checklist”, that showed how a simple checklist could make an enormous impact on outcomes in both simple and complex life-threatening medical procedures. Gawande went on to develop the article into a book, The Checklist Manifesto: How To Get Things Right, that expands his ideas and includes a discussion of how checklists are used by investors Monish Pabrai and Guy Spier.

At the 1998 Berkshire Hathaway annual shareholders meeting, Buffett and Munger discussed another of their basic investment filters – opportunity cost – and how they use it. (1)

Munger explained that if you have the opportunity to purchase an investment that is better than 98% of all businesses, then you can use it as a filter to automatically eliminate the other 98%. Munger conceded that it’s a simple idea and wondered aloud why it has not been more widely imitated because 1) Berkshire Hathaway was proof that it worked, 2) if practiced it tends to lead to a concentrated portfolio (which Buffett and Munger believe is the rational way to invest), and 3) it saves you a lot of time because you can quickly eliminate investment ideas that aren’t in the top 2%.

Buffett went on to explain it this way. Whenever they look at a possible investment, they immediately compare it to Coke, which Buffett views as about as perfect an investment as you will ever find. Coke not only has superior economics and growth prospects far into the future, but also its future prospects are highly certain.

Buffett puts a high premium on certainty. According to Buffett, when you invest you are trying to peer into the future. With many, if not most businesses, it’s either impossible or fraught with uncertainty. With a few businesses, however, if you do your homework, you can develop real and rational conviction about their future prospects.

If a prospective investment does not pass Buffett’s “Coke” or “Gillette” (Gillette was purchased by P&G in 2005) test, he’s unlikely to buy. Buffett went on to say that CEO’s should apply the same filter when sizing up an acquisition. If it doesn’t pass the “Coke” test, Buffett asks why not buy stock in Coke or repurchase shares in their own business? According to Buffett this would have prevented a lot of unsound deals.

This is a simple, yet powerful, filter that you can put to use immediately.

(1) Berkshire Hathaway annual meeting, 1997, Outstanding Investor Digest, August 8, 1997, p. 15.