After talking about buying the best businesses in the world in a prior post some people asked us:
“How do we know what the best businesses in the world are?”
It’s fairly easy to look in hindsight, but of course we don’t know what the best businesses will be in the future, which is where investing profits are made. However, we thought we’d share a tip we use.
The first thing we look for is the return on invested capital (ROIC). Many of you own your businesses so it is easier to think in terms of your own business. The ROIC is simply how much cash you generate each year divided by how much cash has been invested in the business in total. The total cash invested in the business can be found by looking at your balance sheet and adding the equity (the money the owners have put in or retained from prior years’ earnings) and debt (money borrowed to invest in the business).
There is no more simplified metric for determining a great business than its ROIC. The more money you generate on the less capital you need the better a business it is. The best businesses in the world can actually grow without hardly any additional capital being invested. These are rare like black swans.
We like to look at ROIC over 5-year periods, as any one year can be distorted in a cyclical business. It is rare to find a business that can consistently do over 15-20% ROIC over long periods of time.
Warren Buffett has famously described See’s Candy as one the highest ROIC businesses he has ever owned:
“We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. Consequently, the company was earning 60% pre-tax on invested capital. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime, pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire.”
How do you find great businesses? You look for business that generate substantial amounts of cash compared to the money being invested in them!
All the best,
Your Fortis Capital Management Team