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Warren Buffett’s Advice on How You Can Find a Wonderful Business

Credit: The Motley Fool

Warren Buffett is arguably the best investor of our generation, having compounded the book value of his investment company, Berkshire Hathaway, by close to 20% per year for almost five decades.

It’s for this reason that we, investors, have much to learn from him. And to Buffett’s credit, he has never been shy about imparting valuable investing lessons too. In 1991, he did just that when he gave a lecture to the Notre Dame Faculty. A transcript of the lecture had been produced by investor Whitney Tilson and it contains chockfull of investing wisdom (I’d highly recommend everyone to read the transcript).

For me, one that stood out in particular was the contrast in the fates of American Telephone and Telegraph Company and Thompson Newspapers. The former, according to Buffett, had “lost its investors more money than virtually any business in the world.” Meanwhile, the latter had “made one of its owners one of the five wealthiest people in the world.”

The big difference between the two companies is illustrated by Buffett as follows (monetary figures given are in US dollars):

“The telephone company, with the patents, the MBAs, the stock options, and everything else, had one problem, and that problem is illustrated by [the]… plant investment in the telephone business. That’s $47 billion, starting off with, growing to $99 billion over an eight or nine year period. More and more and more money had to be tossed in, in order to make these increased earnings, going from $2.2 billion to $5.6 billion.

So, they got more money, but you can get more money from a savings account if you keep adding money to it every year. The progress in earnings that the telephone company made was only achievable because they kept on shoving more money into the savings account and the truth was, under the conditions of the ‘70s, they were not getting paid commensurate with the amount of money that they had to shove into the pot, whereas Lord Thompson [owner of Thompson Newspapers], once he bought the paper in Council Bluffs, never put another dime in. They just mailed money every year.”

Put another way, the capital intensive American Telephone and Telegraph Company had been a dreadful investment for its owners because the company had to reinvest enormous amounts of capital in the business which then earned little returns. Meanwhile, Thompson Newspapers required very little reinvestment and yet managed to produce respectable returns.

To put the experience of the two American companies into a useful framework, it would be this: Focus on a company’s return on equity and its ability to generate free cash flow. A company’s return on equity measures the returns earned on each dollar of shareholder’s capital used in the firm. Meanwhile, free cash flow is the cash generated by a business after the necessary reinvestments have been made to maintain the firm’s business at its current state.

The following chart shows Raffles Medical Group Ltd (SGX: R01) and Vicom Limited’s (SGX: V01) returns on equity and free cash flow in the decade ended 2013.

ROE and FCF for Raffles Medical and Vicom

Source: S&P Capital IQ

From the chart, we can see that Raffles Medical and Vicom have both generated very healthy returns on equity of more than 15% for most of that decade. In addition, the two firms have also generated consistently growing free cash flow.

We can contrast this with a firm like Singapore Airlines Ltd (SGX: C6L). The legacy carrier’s financials are displayed in the chart below.

ROE and FCF for Singapore Airlines

Source: S&P Capital IQ

Unlike Raffles Medical and Vicom, Singapore Airlines has earned poor returns on equity for the most part between 2003 and 2013 and had never been able to generate consistent free cash flow.

A Fool’s Take

With the difference in the quality of their businesses, it’s perhaps no surprise to find that there’s a large gulf in the long-term returns for Singapore Airlines as compared to Raffles Medical and Vicom. Since the start of 2004, Singapore Airlines has delivered negative capital gains of 6.7%; meanwhile, the other two shares have seen their share prices soar by 964% and 644% respectively.

When it comes to long-term investing, finding a quality business is important – and Buffett has given some great tools for spotting one. Although a company’s free cash flow and returns on equity are certainly not the only important figures investors should focus on, they can still provide valuable insight about the quality of a business.

For more FREE investing stories, market commentary, and analyses, sign up to The Motley Fool Singapore's weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it will teach you how you can grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway and Raffles Medical Group.