5 Qualities of an Excellent Business
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It always pays to look at investing from a long term viewpoint. When you hold a stock for the long term, commission costs and taxes are held to a minimum. However, feeling comfortable about taking ownership in a business for the long term starts with understanding what qualifies it for excellence.
1.) Barriers to entry – Companies that tend do well over time are well-protected from the competition due to a unique product or expensive infrastructure. Competition merely eats away market share for a business’ product. A lack of competition gives companies pricing flexibility, boosting revenue and free cash flow in the process.
For example, beverage giant Coca-Cola (NYSE: KO) has only two major competitors; Pepsico and Dr. Pepper Snapple. Coca-Cola possesses relationships with a vast distribution network, providing a major barrier to entry and allowing it to efficiently and cheaply distribute its syrup and finished products across the globe. It would take a great deal of capital to set up a system to effectively compete with Coca-Cola. If it needs to raise prices it can do so without the worry of multiple competitors undercutting them.
This major barrier to entry, among other factors, contributed to a market beating return of 19% versus a loss for the S&P 500 over the past five years, according to Yahoo! Finance.
2.) Sells a needed product – Another attribute of an excellent business, selling a needed product, can provide shareholders with market-beating returns. Companies that operate in “need based” industries such as transportation, food, and agriculture possess greater than average potential in providing shareholders with wealth.
Food conglomerate Kraft (NASDAQ: KRFT) sells needed products such as mayonnaise, cheese, and stove top stuffing. Basic human needs don’t change, which can provide comfort to shareholders owning shares of companies that cater to them. Kraft’s pre-spin off version returned 20% to shareholders over the last five years.
3.) Generates and keeps cash – Owning stock means being a part owner of a business. Most business owners, small and large, want their enterprise to generate money for them. A public shareholder should harbor the same attitude.
Homebuilder NVR (NYSE: NVR) generated cash and added to its balance sheet when other homebuilders were struggling to make ends meet. NVR did this by not making significant cash commitments to projects until a customer was found. According to Yahoo! Finance, NVR gave its shareholders a 75% return, versus a loss from the S&P 500 over the past five years.
4.) Expansion – A business owner wants to see the business grow. A growing business means growing revenue and cash flow. Any management team worth their salary will work to expand the business they are charged with running.
Even with retail behemoth Wal-Mart (NYSE: WMT), management seeks to expand into new territory with its smaller format stores, creating future opportunities for revenue and free cash flow growth in addition to establishing dominance in new markets.
According to Yahoo! Finance, Wal-Mart returned 43% to its shareholders, not including dividends, over the last five years, versus a loss for the S&P 500.
5.) Management ownership – Companies with large management ownership ensure excellent stewardship of the business. If a manager stands to lose a huge chunk of his or her net worth they will take better care of business.
The Chairman of apparel and accessories retailer Buckle (NYSE: BKE), Daniel J. Hirschfeld, owns 34% of the company, according to its latest proxy. His stewardship shows. Buckle grows its revenue and free cash flow during good and hard times. The company pays a generous dividend to its shareholders year after year instead of the usual share repurchases.
Buckle’s share appreciation amounted to 80% over the past five years versus a loss for the S&P 500.
Not all of the above companies will exhibit all of the traits here. An owner of a public or private business wants to make cash without pesky competitors getting in the way. The owner or stockholder would be wise to partner with a manager with a huge stake, ensuring the alignment of their interests with the rest of the shareholders. A successful long term investor benefits from a strategic and partnership-ownership mode of thinking.
stockdissector has positions in Coca-Cola, Kraft, and Buckle. The Motley Fool owns shares of The Buckle. Motley Fool newsletter services recommend The Buckle and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!