Finding great businesses to invest in over the long-term can be a very profitable strategy in the stock market. But what are some characteristics of a great business? Jeff Bezos, the founder and leader of online retail giant Amazon Inc., is someone who knows a thing or two about the subject. The company was listed in the U.S. in 1997 and through Bezos’s leadership, has become a phenomenal success. Just look at its stock price chart below: Source: S&P Capital (click for larger image) In Amazon’s latest 2014 annual shareholder’s letter, Bezos shared his definition of…
Finding great businesses to invest in over the long-term can be a very profitable strategy in the stock market. But what are some characteristics of a great business?
Jeff Bezos, the founder and leader of online retail giant Amazon Inc., is someone who knows a thing or two about the subject. The company was listed in the U.S. in 1997 and through Bezos’s leadership, has become a phenomenal success. Just look at its stock price chart below:
Source: S&P Capital (click for larger image)
In Amazon’s latest 2014 annual shareholder’s letter, Bezos shared his definition of a “dreamy” business:
“A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.”
To Bezos, there are four elements that combine to form the perfect business. They are (1) strong consumer appeal, (2) a huge runway for growth, (3) the ability to earn great returns from the capital invested, and (4) the ability to last the yard.
I think that’s a very sensible mental filter to use when thinking about how good a business is. It’s also why I think commodities trader Noble Group Limited (SGX: N21) has a lousy business. Here are the reasons:
1) Strong consumer appeal
Strong consumer appeal helps lead to pricing power ultimately. But the latter is something which is absent for companies in the commodities space. Commodity producers or traders are essentially price-takers – they can’t exert much control over the pricing of their products. That’s the situation for Noble.
2) Huge runway for growth
Commodities will likely have strong demand even years into the future (commodities are after all, the raw materials needed to build new gadgets and toys and to feed the world).
Noble’s astonishing revenue growth – a nearly seven-fold jump from US$11.7 billion in 2005 to US$74.7 billion over the last 12 months – is also a testament to the company’s room for growth. But – and that’s a crucial ‘but’ – revenue growth alone isn’t sufficient.
3) Ability to earn great returns on capital invested
From 2005 to 2014, Noble had spent a total of US$4.8 billion on capital expenditures. But, there are signs that Noble’s investments into its own business hasn’t been generating sufficient returns.
For instance, Noble’s negative US$46 million in operating cash flow in 2005 had sunk to a negative US$1.1 billion by 2014. Meanwhile, the company’s profit had also shrunk by nearly half from US$232 million to US$132 million over the same period. In the past five years from 2010 to 2014, there were even three calendar years when Noble had poor single-digit returns on equity.
4) Ability to last the yard
As I had said earlier, the demand for commodities will most probably remain for a long time to come and that can mean that companies dealing with commodities have the “potential to endure for decades.” But – again a crucial ‘but’ – those companies can skew the odds against themselves by taking on huge amounts of debt.
Borrowed money can help create value for shareholders when used intelligently. But, it also adds risk, especially when copious amounts are piled onto the balance sheet. Noble currently has a net-debt (total debt minus cash & equivalents) to equity ratio of 82%; that’s not low, and thus makes the company’s balance sheet risky.
A Fool’s take
Given what we’ve seen above, Noble lacks the traits of a great business. This does not say anything about its investing merits at the moment however – lousy businesses can still make for good investments if their share prices are way below their intrinsic economic values. That’s something we’ve yet to explore with Noble.
All told, investors who are interested in finding great businesses may want to approach Noble with caution.
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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 Amazon.