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Warren Buffett and Charlie Munger: What Does the Ideal Business Look Like?

A key question for investors of any stripe is: what constitutes a good company? At the 2003 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) annual shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked what they consider the essential characteristics of a good business to be. Here is what they said.

The best businesses scale

Over the years, Buffett and Munger have given many definitions of what a good business should have. Strong management and a wide moat are two of the most commonly-cited attributes of good companies. However, there is a more fundamental characteristic that underlies those ones: the business' ability to earn high returns on capital:

"The ideal business is one that earns very high returns on capital and can keep using lots of capital at those high returns. That becomes a compounding machine. So if you put $100 million into a business that earns 20% on that capital, say $20 million, ideally, it would be able to earn 20% on $120 million the following year, and $144 million the following year and so on. You could keep redeploying capital at those same returns over time. But there are very, very few businesses like that."

The problem is there are very few businesses like this. Ask anyone who has ever attempted to build a profitable company - it's hard enough to pull that off, let alone create something with the potential to scale. Buffett said the majority of the businesses acquired by Berkshire over the course of its history have been companies with good returns, but limited ability to scale:

"The good businesses, like Coca-Cola or See's Candy, don't require much capital. And incremental capital doesn't produce anything like the fundamental return that's produced by some great intangible. So we would love the business that could keep deploying [capital]. We'd love to have a business that could earn 20% on $120 million now, and if we put in $1 billion more into it, it would earn 20% more on the billion. But like I said, those businesses are so rare - there are lots of promises of those businesses - but we practically never see them. Most of the great business generate lots of money; they do not generate lots of opportunities to earn high returns on incremental capital.

We can deploy X at See's and earn a lot of money, but if we put 5 times X in, we don't earn any more money. We can earn high returns on X at the Buffalo News, but if we try to make it 5 times X, we don't earn any more money. They just don't have the opportunities to use incremental capital. We looked for them, but they don't [exist]."

This is a fine situation for an owner who simply wants to take the cash generated by the business out of the company coffers and live off it, or perhaps spend lavishly on luxury items. For Buffett and Munger, however, spending recklessly is hardly their style. They are focused primarily on finding new ways to deploy capital efficiently. In the next part of this series, we will look at why the Berkshire Hathaway corporate structure is so well-suited for achieving this goal.

Disclosure: The author owns no stocks mentioned.

Read more here:

  • Warren Buffett and Charlie Munger: Become a Better Investor by Using Feedback Mechanisms
  • George Soros' Investment Philosophy, Part 3
  • George Soros' Investment Philosophy, Part 2

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This article first appeared on GuruFocus.