This case study will provide an overview of the Coca-Cola Company as the perfect business as it pertains to the characteristics that make up a good business. A series of three questions will be discussed. Identifying four characteristics of a good business, identify four companies that display these characteristics, and in three years after purchasing common stock in these companies determine if the present analysis was correct.
Discuss at least four characteristics of a good business There are many highly successful investors, each having their own criteria for what constitutes a good business. I chose to look at Warren Buffet and his investment principles. No one can argue his success as an investor. High ROE – The return that a company gets on its equity is one of the most important factors in making successful stock investments.
The higher return on equity allows a company to invest surplus funds back into the company. This means there is less need for owners/stockholders to invest additional funds and there is less need to borrow. (Warren Buffett’s Secrets, n.d.) High/Free Cash Flow – A measure of financial performance and stability is calculated as operating cash flow minus capital expenditures. Free cash flow represents the cash that a company has on hand after it maintains and/or expands its asset base. This is important because it allows a company to pursue opportunities that enhance shareholder value. With little or no cash, it is difficult to develop new products, make acquisitions, pay dividends and most importantly reduce debt.
The biggest concern is long-term debt. Increases in interest rates can drastically affect company profits and make future cash flows less predictable. (Investopedia) Earning Capacity/Growth – When a company grows its profits grow, as do returns to the investor. The important thing to consider as an investor is that the company increases the returns to shareholders. One thing to look at is earning capacity and growth follow a predictable path over a period of time. A company that grows with little or no increase on returns to investors is doing so at the investor’s expense.
This is not generally a good investment sign. Management – Investors should only invest in companies with managers of competence, integrity, and a proven track record of successful management. Companies should stick to what they do best and not expand for the sake of expanding. The best companies are doing today what they were doing in the past and what made them successful. Look for company management that has a track record of consistent growth in earnings and ROE and they take a conservative philosophy to debt and being liquid. (Warren Buffett’s Secrets, n.d.)
Identify and discuss at least four companies that display these characteristics By looking at the investment philosophies of Warren Buffett it is a logical step to look at companies that are in his personal portfolio and those in Berkshire Hathaway. Each of the following four companies demonstrates the characteristics of a good business. Coca-Cola – It demonstrates the attributes of a successful company. It has a strong management team that has produced consistent, predictable returns, and growth for many years. It is a large capitol-intensive company that has produced a long history of above average returns.
The average ROE has been higher than what is the norm. For the most part Coca-Cola has stuck to what has made it successful. With the exception of the “New Coke” debacle in 1985 it has stayed simple and direct in its operational philosophy. American Express - American Express Company has separated its credit card and lending business into three main businesses: U.S. card services, international card and global commercial services, and global network and merchant services. By doing so American Express has become very successful placing itself in a lucrative niche in the financial service markets.
This gives it a closed looped network with products and services that allow it to have a competitive advantage on pricing. Another strong point is at the time of this writing American Express was trading under our fair value computation. It is also consistently returning strong dividends, has a great price-to-earnings ratio, and a ROE that is triple the industry average. (Morris, 2011) Johnson and Johnson - Johnson and Johnson have had consistent dividends that are yielding 3.3%.
It is a company that operates in the drug manufacturing industry but is very diversified with hundreds of different products, which fall into their sub categories: pharmaceutical, medical devices and diagnostics, and consumer. Given the aging population and the increasing need for the products they provide Johnson and Johnson is set to deliver solid steady performance with high company predictability. (Morris, 2011) Wells Fargo - Wells Fargo is a well known for its great upper management. Because of their strong management Wells Fargo was able to recover from the banking demise over the past two years.
Wells Fargo saw stocks dip to a low of $8.61within four months management had the company back into a 52-week average. As of this writing the stock is trading at $28.91. With a price to earnings ratio of 11.9 and declared dividends five times in the last six months, it is easy to say this is a strong stock. Another strong point is in the last three quarters, revenue growth was double the industry average. (Morris, 2011) After purchasing common stock in these companies and looking ahead three years, determine if the present analysis was correct
If after the three years each of these companies were continuing to return investments at above normal rates, maintained consistent growth with a predictable forecast then the analysis would be correct. Also continuity of the management team for each company is of critical importance. Excellent management is a common thread between each of these companies. This is one area that cannot be overstated.
Each of these companies at one time or another has experienced difficulties and was able to recover and become stronger. These companies are positioned on solid, conservative management. In the difficult times when the competition is failing these companies are able to absorb the losses or declines and recover to a position of greater strength.
If after the three years the returns are not above average and the company is not operating from a position of strength then the analysis would be wrong. But there are additional factors to look at before one could or should jump to that conclusion. What is the state of the economy, how are their competitors doing, have there been large investments into the company designed for future growth and profitability. Short-term results are not necessarily and indicator of success or failure.
In conclusion each of these four companies demonstrate the characteristics of a good business. Otherwise Warren Buffett and others would not be investing in them. The first key to investing and realizing an above average return on that investment is to identify those companies whose management teams demonstrate these characteristics. Secondly, finding those companies whose stocks are undervalued and have the potential for success. And finally having the patience to ride through the ups and downs of the short-term into a long-term financial success.
References Warren Buffett’s Secrets. (n.d.). Investment Principles of Warren Buffett. Retrieved from http://www.buffettsecrets.com/buffett-investment-principles.htm
Investopedia. (2011). Free Cash Flow – FCF. Retrieved from http://www.investopedia.com /terms/f/freecashflow.asp#ixzz1c068RZpi
Morris, S. (2011, May). American Express: The Best Stock in Warren Buffett’s Portfolio. Retrieved from http://seekingalpha.com/article/271111-american-express-the-best-stock-in- warren-buffett-s-portfolio