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Finding Wonderful Businesses: Invert, Always Invert

- By Rupert Hargreaves

Finding wonderful businesses is easy. All you need to do is look for companies that are earning high returns on invested capital, which most investors can do with a simple stock screener.

However, the hard part is finding the companies that are both wonderful businesses and have a strong competitive advantage that will allow them to remain so for the foreseeable future. This is not easy. If it was, everyone would be a great investor.

Warren Buffett (Trades, Portfolio) knows a thing or two about finding businesses that have wide and deep economic moats, and he has been helped along the way by his right-hand man Charlie Munger (Trades, Portfolio).

How to find wonderful businesses

In the book, "Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger (Trades, Portfolio)," Munger gave some insight into how he goes about finding attractive businesses. He said:

"Frequently, you will look at a business having fabulous results. And the question is, ' how long can this continue?'"

"Well, there's only one way I know to answer that. And that's to think about why the results are occurring now -- and then to figure out what could cause those results to stop occurring."

In other words, Munger believes that the answer to this question, like so many of life's questions, can be answered by flipping the question on its head. Investors should be asking what could stop the company from generating fantastic returns, rather than why the company is generating fantastic returns.

This goes back to one of Munger's favorite principles in life: inversion, or as Munger himself has put it, "Think forwards and backward -- invert, always invert."

Berkshire Hathaway (BRK-A)(BRK-B)'s vice chairman believes that many problems in life are best solved when they are addressed backwards. This is because the human mind finds it easier to solve problems when they are proposed in reverse. As Munger once explained:

"Many hard problems are best solved when they are addressed backward. The way complex adaptive systems work and the way mental constructs work is that problems frequently get easier, I'd even say usually are easier to solve, if you turn them around in reverse. In other words, if you want to help India, the question you should ask is not 'How can I help India?' It's, 'What is doing the worst damage in India? What will automatically do the worst damage and how do I avoid it?' Figure out what you don't want and avoid it and you'll get what you do want. How can you best get what you want? The answer: Deserve what you want! How can it be any other way?"

This concept has many more uses than just helping identify whether or not a company has a sustainable competitive advantage. It can be used in all aspects of investing and indeed life.

Risk not reward

The highly respected value investor Seth Klarman (Trades, Portfolio) has said on many occasions that the primary factor any investor should be concerned about when deciding where to invest their money is risk.

He believes an investor should approach a company by asking the question, "How much can I lose?" rather than, "How much can I make?"

In many respects, this principle is exactly the same as Munger's "invert always invert." by looking at the company from a different perspective, i.e., what could go wrong rather than what could go right, you may identify different factors that you will have overlooked if approached from the opposite direction.

For example, a highly leveraged company might say that it has debt under control, but if you think about this from a risk perspective, how many companies have claimed to have debt under control but have then collapsed?

Viewing the business in isolation from a positive "how much can I make" perspective will certainly yield a different conclusion from the "how much can I lose" perspective.

Disclosure: The author owns no share mentioned.

This article first appeared on GuruFocus.