The 5 Elements That Make For An Outstanding Business

It’s often as much art as it is science to uncover the key elements that go into finding exceptional businesses. However, making an effort to distill some of these items into a more formulaic process is arguably well worth the effort. Businesses that can generate substantial shareholder value can provide investors with significant outperformance compared to investing in an index like the S&P 500 (SPY).

While there are no doubt many intangibles that go into the process of generating high returns, it’s been my experience in managing my own growth portfolio that there are a few key factors that strongly contribute to performance.

Outstanding Returns on Invested Capital

According to Charlie Munger:

It is hard for a stock to earn a much better return than the business that underlies it.

Intuitively, this makes sense, because the cash generation that occurs from the business earning high returns on assets can be put to work to further invest in new opportunities and create additional assets that can, in turn, earn higher returns for the business.

It’s a virtuous cycle of steady and aggressive compounding at high rates of return that can contribute to long-term wealth creation. Various quantitative research studies confirm and support this idea. A study by Forbes found almost a 60% correlation between returns on invested capital and stock returns for a business.

Source: Forbes

Strong Cash Generation

Businesses that are capable of generating strong cash flow often have many advantages over those that don’t. During the pandemic, it’s been fairly obvious to see the strategic advantages of having excess cash. At its most basic level, this avoids having to undertake an expensive capital raising at a point in time when a stock price is at its weakest or having to run to the bond markets to raise additional capital.

While businesses like United Airlines (UAL) and Ford (F) have had to request government assistance or contemplate other costly strategic capital-raising initiatives, businesses like Alphabet (GOOG, GOOGL) and Facebook (FB) that have $150 billion and $50 billion in cash reserves respectively have been able to get by without needing to resort to any such measures.

However, not only is cash a valuable option to help play defense in difficult times, but it allows a business to go on the offense to undertake value-accretive, strategic transactions. Facebook acquired both WhatsApp and Instagram in a stock and cash transaction, with the cash outlay alone over $4 billion. Both acquisitions which were hugely transformative in terms of helping the business tap into new market demographics and platforms and markedly expand its competitive position.

Finally, strong cash generation provides businesses with the ability to buy back shares, effectively wiping out share count and driving up long-term earnings per share for shareholders, also contributing favorably to investor returns.

Apple (AAPL), Visa (V) and Mastercard (MA) are particularly voracious in deploying share buybacks. All have reduced their share count by between 20% and 30% over the last 10 years, while their stock prices have soared almost 1000% over this time. Clearly, stock buybacks aren’t the only contributing factor to this, however, they have been helpful in increasing stock price.

(Source: YCharts)

Sustainable Competitive Advantage

One of my principal areas of focus in the investments that I select is to find elements of defensibility in the competitive positioning of a business, which leads to long-term sustainable growth. This is particularly important to me because I like a low-touch, low-turnover method of portfolio management. I invest with the intention of a long-term holding period, to allow my businesses to compound capital in the most efficient way possible with minimal tax leakage and without excessive trading costs.

Source: Morningstar

In order to be able to do so with conviction, it’s incredibly important that there are competitive barriers in place which preserve the ability of a business to keep compounding capital. While Morningstar.com identifies 5 key moat sources, I’ve particularly gravitated to network network effects and switching costs as my preferred moat source. The network effect competitive moat is something which businesses like MercadoLibre (MELI), Alibaba (BABA) and Amazon (AMZN) possess, and is particularly prevalent in two-sided platform businesses. The nature of the network effect moat source is that business value strengthens as new users and new merchants come on these platforms, providing incrementally more utility to each party with each new addition. This results in a rich and vibrant ecosystem that delivers significantly more value than that which they could get on alternate platforms.

The presence of high switching costs is also another personal favorite and is found in other holdings such as Salesforce (CRM) and ServiceNow (NOW), where having to move to alternate platforms generates strong user fiction, with salespeople or IT users having to be retrained on a new platform. Such migration also creates a fear of potential data loss in the transition, which adds to the friction of making any change.

There is some evidence to suggest that investing on the basis of sustainable competitive advantage can lead to the identification of outstanding businesses that can drive long-term returns. Morningstar has formulated its approach in the form of a wide-moat index, which has produced long-term outperformance versus the S&P 500.

Source: VanEck

Founder-Led Businesses

Research from Bain & Company suggests that the returns of publicly listed, founder-led businesses are significantly higher than those that are governed by a professional “corporate manager”.

Source: Bain & Company

Some of this is just because founders have their incentives better aligned with shareholders, with founder CEOs such as Marcos Galperin of MercadoLibre having close to 10% of his net wealth in the business.

However, it’s not just the equity alignment that is important, it’s also the vision and strategic direction that these founders bring to the business. I believe that this is particularly relevant in new markets, where value is created through the power of disruption or challenging status quo.

Founders in new markets tend to have very deep expertise in their particular industries and a vision for how those industry should be transformed and operate. MarketAxess (MKTX) founder Rick McVey noticed a pain point in the inefficiency of bond transactions, with a direct buyer-to-seller relationship not allowing for optimal bond price discovery and creating transaction inefficiency. Twilio (TWLO) founder Jeff Lawson had a vision of telecommunications being brought to the masses quickly and efficiently in a scalable way, rather than developers having to deal on a case-by-case basis with complex telecom carrier negotiation.

Finally, Trade Desk (TTD) founder and CEO Jeff Green saw the lack of transparency for brands in existing walled garden approaches in digital advertising, as well as the opportunity that new formats in connected TV and connected audio could deliver to advertisers. It likely would have been significantly difficult, if not impossible, for more traditional, hired gun corporate managers to be able to realize the transformative value creation in these new areas.

Intense Customer Love

This particular attribute tends to be a little more intangible to measure and difficult to define. A study by Watermark Consulting in 2016 which measured Customer Experience (which can be considered as a proxy for user engagement and loyalty) showed that enterprises with better customer experience saw significantly better long-term share returns than those that were laggards.

Source: Watermark Consulting

While perhaps difficult to measure, customer engagement and love is something that can be observed without too much effort. it’s something that can be seen in the long lines outside of Apple (AAPL) stores just prior to any new device release.

It can also be seen and measured in the incremental and increasing spend that existing customers generate with enterprise software businesses through a process of “Land and Expand”. The fact that Alteryx (AYX) improves the productivity of highly stressed data analysts results in these analysts evangelizing the product to other data scientists within the business, contributing to a dollar-based retention rate of 140%, or an increase in spend of close to 40% for existing customers every year.

Finally, rapid increases in market share away from incumbents to a new disruptor also tend to be indicative of customer love or someone solving a pain point that isn’t easily addressed. Tesla’s (TSLA) rapid gain in EV market share in the US over a very short space of time is a pointer to intense customer love and a product that customers are willing to pay a premium for.

Source: BloombergNEF

Concluding Thoughts

While the identification of businesses that can generate tremendous value isn’t necessarily something that’s easy or straightforward, having some identified checklists can ease that process and provide pointers for businesses that are capable of generating long-term value creation. Of course, the identification of a relevant business is really just a starting point, and being able to acquire that business at a price that makes sense it’s just as critical to long-term returns.

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Disclosure: I am/we are long MA, V, FB, CRM, NOW, GOOGL, MELI, AMZN, MKTX, TTD, TWLO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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