How To Find Exceptional Businesses?
"Buy exceptional companies and do nothing" is the formula of success in investing. But... How to find such exceptional companies? Let me explain.
If you asked me to formulate successful investing in a sentence, I would say this:
“Buy companies with durable competitive advantage at attractive prices and do nothing.”
Doing nothing and buying at attractive prices are generic actions in the formula that depend on the critical ingredient: Companies with durable competitive advantage.
You buy them at attractive prices, you hold them and do nothing.
It’s just like KFC chickens.
Chicken and oil are generic ingredients that everybody knows but what makes them KFC is a specific mixture of spices.
That secret recipe, luckily, leaked in 2016:
Such a secret recipe doesn’t exist for exceptional companies. They come in all shapes and colors and the only thing we know is that all exceptional companies have durable competitive advantages.
Buffett and Munger have pronounced this for decades in all their writings and speeches. For instance, this is what Warren Buffett wrote in 1991 Berkshire Shareholder Letter:
An economic franchise arises from a product or service that 1) is needed or desired, 2) is thought by its customers to have no close substitute, 3) is not subject to price regulation.
Warren Buffett, 1991 Shareholder Letter
So, the question is clear: How do we find such businesses?
I am pretty sure that most investors have no idea about what exceptional businesses are and they’ll just give you some platitudes. The real good investors, on the other hand, will emphasize one critical metric: “Return on Capital Employed.”
Well, like most mainstream knowledge, this isn’t necessarily true.
It’s still better than having no idea or throwing out just a bunch of platitudes, and you’ll likely generate better results if you follow this rule of thumb than those who don’t.
Yet, it doesn’t mean it’s true.
Return on capital employed is just a metric that flows from the characteristics of the business and yes exceptional companies tend to generate exceptional ROCE.
Buffett also touches on this in the same letter:
The existence of all three conditions will be demonstrated by the company’s ability to regularly price its product or service aggressively and thereby earn high rates of return on capital.
Warren Buffett, 1991 Shareholder Letter
Yet, what we have is just a metric after all. It’s a number on the paper and it doesn’t help our understanding of exceptional businesses.
When asked what makes an exceptional business, you can’t say high ROCE. It’s a result not a reason.
Yet, we keep trying to explain this phenomenon by resorting to numbers.
Why do we do that?
I think there are two main reasons:
When we learn something, we want to formulate it so we can apply it consistently.
We also want such formulation, to teach it to other people so they can apply it for us while we elevate ourselves to a more passive position.
Yet, I believe formulation doesn’t appropriately serve these objectives.
I think we can consistently apply what we have learnt by being guided by intuition instead of formulas. This is called experience.
I also find ridiculous the idea that formulation yields better results than observation in spotting qualitative properties.
Think about teaching somebody how to spot good humans and you give them the money they donated to charity as an indicator.
How good would that work?
On the other hand, I think a reasonable and smart person can easily understand whether anybody is a good human or not by spending time with him for 10 days.
You just look at how he behaves to other people, how he talks when others are present and not, whether he shares his personal belongings or not etc…
For instance, good people treat others who serve them very respectfully. They are nearly ashamed of being served. They talk to waiters in the restaurants, taxi drivers, janitors very respectfully and show their gratitude in every way possible. On the other hand, a person who dares to yell at a waiter in a restaurant can’t be a good person regardless of the sizes of his donation checks.
If you are willing to put in the work and effort, observation combined with background knowledge is very very powerful.
I think that applies to finding exceptional businesses too.
So, I want to do something here that has never been done.
Instead of giving you some metrics to observe, I will try to directly explain to you what are the exceptional businesses relying on background knowledge and observation.
This is not an exhaustive list, but it’s a fairly comprehensive one.
So, let’s cut the BS and get started:
1. Toll Bridges
Toll bridges tend to be amazing businesses if there are many people that have to use the bridge.
What does a toll bridge do? It’s a connection between two points.
It makes money by imposing a fee on everybody that wants to use the bridge to get from point A to point B.
When you think about that, economic characteristics that make a toll bridge valuable instantly becomes apparent:
It's better business if there are many people that want to cross the bridge.
It’s even better if the bridge is the only connection between the two points.
It’s best if there are many people using it and it’s the only connection.
In businesses, toll bridges are the companies that cut commission on usage.
Best examples are payment processors: Visa, Mastercard, American Express…
If you want to use your credit card in payment, Visa and Mastercard are the two widely used processors. What they simply do is to connect your issuer bank to the receiver bank, they act exactly like a bridge. In doing so, they cut a commission based on the volume of that transaction.
When such a network is used by many people, it grants some amazing properties to the underlying business. They become inflation proof and recession proof at the same time.
Think about an inflationary scenario: Their earnings will go up because the total basket sizes will grow due to inflation.
In a recession, they will be affected less than other businesses because payments for the existing demand will still be processed by their networks.
Plus, their wide usage also creates very strong network effects.
What does this mean? Imagine you are a bank that wants to issue a credit card. Which processor would you choose? You would choose either Visa or MasterCard because you want your card to be accepted at as many points as possible.
Thus, the business grows even further with each new card issued.
Payment processors are just one type of toll bridge. There are too many and you can spot them by observing whether they use the business model of connecting two points and cutting a commission instead.
Remember, whatever your toll bridge is, the critical points in the success of these businesses are the number of people who need to use a bridge and how many bridges there are.
Once they are successful, network effects tend to make that success self-perpetuating.
2. Multi-Sided Platforms
In real life, platforms tend to be seamless as most of the emphasis is on the buyers and sellers.
Think about shopping malls for instance.
They are actually double-sided platforms: They house sellers and invite buyers, thereby meeting demand with supply.
The main reason these mediums are seamless in real life is that their scale remains small given the physical constraints. A shopping mall could only take up so many stores and visitors. Imagine how big a mall you need to accommodate a million visitors?
The Internet removes this constraint on scale.
A platform needs only a bigger database and bandwidth that are not limited resources. This is why multi-sided platforms that meet demand and supply thrive on the internet.
Take Facebook as an example.
It meets advertisers with eyeballs on a scale that is unprecedented because it doesn’t face any constraints that physical platforms face. On top of that, it enjoys network effects that physical platforms don’t.
For every platform, there is a specific user count called “critical mass”. It refers to the number of users when reached, it’s more attractive for any prospective user to join that platform rather than any other platform.
Take Instagram for instance. It has reached critical mass. How do we understand this? Because most users already have more friends on Instagram than anywhere else, so the natural place to start a social media platform for them is also Instagram.
This creates incredibly strong double-sided network effects:
More users attract even more users.
More users also attract more advertisers.
More advertisers also attract more advertisers because of competition.
The crucial point here is the “critical mass.”
It’s very easy to create a social media platform, it’s incredibly hard to reach the size of Facebook or Instagram. Somewhere between 0 users and the current 2 billion users Instagram has, there is a point called “critical mass”, when reached, network effects become so strong that the growth sustains itself.
When evaluating such models, understanding if the business has reached the critical mass is the most important thing.
If it has, you are probably looking at a business that will dominate its market and generate massive shareholder wealth for decades to come without much competitive threat.
Such are indeed exceptional businesses.
3. Tech Ecosystems
This is probably my favorite type.
Sometimes, a product becomes so dominant that creating complementary products for that also becomes a huge market.
The best example is probably the Apple ecosystem.
The iPhone became so dominant of a product that creating applications for iPhone has also become a huge industry where some applications reached hundreds of billion dollars in valuation.
Microsoft Windows would be another example.
It’s been so dominant in the PC industry for many decades that creating applications for Windows is a huge business with millions of applications ranging from games to productivity tools are currently in the market.
When an ecosystem is formed around a product, it grants a massive moat to the company that owns it because other stakeholders also get deeply invested.
It is easy to threaten a product’s dominance. You just need a better product.
On the other hand, a better product usually does no damage to an ecosystem because poaching a few users doesn’t mean anything. As long as there are armies of developers creating complementaries for those dominant products, their position will remain strong because these complementaries will attract more users and more users will attract more developers.
Plus, it’s always possible for an ecosystem company to launch complementary products itself in the sub-markets where it sees an opportunity.
When it does that, it tends to crush all the competition in the sub-market because of its ownership of the distribution.
Here is an example:
Slack has been the best collaboration application in the market for years, and I think it still is. Yet, this market is won by Microsoft because it has the distribution.
Once it launched it in the Microsoft 365 bundle that virtually every business in the world uses, its usage exploded and people suddenly couldn’t find any reason to bring in a third party app rather than using a provider that they have known for long.
In sum, successful ecosystem owners tend to be perhaps the most exceptional ones of all the exceptional businesses, as demonstrated by the fact that Apple and Microsoft are currently the 1st and 3rd most valuable companies in the world.
4. Consumer Monopolies
What I have observed over the years is that people have largely erroneous views about monopolies.
When said “monopoly” most people think about a company that has near 100% share in one product market.
These companies are surely monopolies, but they aren’t the only ones.
We are so wired to think in terms of commodities that we think Coca-Cola has a large market share in the soft beverage market rather than thinking that it holds a monopoly in selling Coca-Cola.
This is the other type of monopoly, which is even stronger.
These companies have unique products that are protected by intellectual property and brand, granting them a monopoly over that product.
Coca-Cola Company sells all the Coca-Cola sold in the world, all iPhones are sold by Apple and all Nike shoes are sold by Nike.
You may object to this by saying that there are many boutique brands that sell unique products.
You are right.
For a business to be regarded as a consumer monopoly, we need three conditions:
Unique product.
Very large scale.
Frequent consumption.
They sell the same unique product to millions of existing and new customers again and again.
These are cumulative.
Think about Coca-Cola:
Its taste is unique, no drink tastes exactly the same as Coca-Cola.
It sells to billions, not millions, of people across the world.
Same people sometimes consume a few times a day.
This is how you get a consumer monopoly.
Once a product reaches this level, it can aggressively price its products, driving growth even if the organic growth stalls. This way, they can grow high-single digits for decades, which is enough to create exceptional wealth if you are patient.
Just remember the three conditions here: Unique product, large scale, frequent consumption.
5. Low Cost Providers With Scale and Scope
I am not talking about the businesses that compete on margins here, I am talking about the perpetual cost cutting machines that also pass some of these savings to their customers.
These are Costcos, Walmarts, Amazons of the world.
This cannot be achieved just by looking at the competitors’ margins and adjusting your markups accordingly to sell cheaper than them. Being exceptional aside, these are the companies you should run away from without looking back.
Being a consistent low-cost provider requires a business model that was set up to support this strategy and developed over years to sustain it.
Think about it. Can your local grocery store suddenly decide to become the lowest cost provider?
His fixed costs wouldn’t allow it:
Located in an urban area, he probably pays more for rental space than competitors located outside the center.
Given his small scale, he probably can’t get the same deals from wholesalers that bigger supermarkets can get.
Result? There is a limit on how cheap he can go without going bankrupt.
Take Costco on the other hand, you have a business model that was deliberately built for perpetual cost cutting:
It builds huge warehouses outside urban centers. This minimizes rental/construction cost per square meter.
These warehouses have capacity for millions of products, giving Costco amazing bargaining power over its suppliers.
It passes some of these cost savings to customers which attracts more customers and further reinforces its bargaining power and reduces fixed costs per product sold.
Result? You get a perpetual cost cutting machine. Costco calls this “Costco Flywheel”.
When you think about other perpetual cost cutting machines, you can easily see a similar design.
Think about Amazon.
It builds giant distribution centers outside urban areas, minimizing storage and distribution costs because they disperse over millions of products. Thus, it can offer wider selection, cheaper prices and faster delivery than any other competitor.
This is called “Amazon Flywheel”.
The critical point about these businesses is that they must have been built on a business model that allows them to pursue this strategy. You can’t just come out of nowhere and be a low-cost provider.
You must have an engine that perpetuates cost cutting so you can have consistently low prices.
This is what you should be looking for in these businesses, whether the model perpetuates cost cutting or not. This is the most critical point.
6. “Expertise” Monopolies
These are the companies that integrate existing technologies and processes in a uniquely complex way that no one else can match.
The best example would be ASML.
It has 100% market share in Extreme Ultraviolet Lithography Machines (EUVL) that are essential for cutting edge chip manufacturing.
This machine is as big as a two story bus and it is composed of more than 100,000 unique parts.
Though ASML itself invented and manufactured some parts to create this machine, it outsources most of the parts and then assembles them to create this machine.
Yet, it does this in a very unique way that it’s impossible to match by any other competitor. To do that, it has run joint R&D processes with hundreds of suppliers, invested in them to ensure consistent availability of the parts and even acquired some of the critical suppliers that it thought couldn’t be trusted.
It took nearly two decades to create a working EUVL machine.
The level of expertise it takes to replicate this is immense and even if you are completely capable and you try, it’ll take at least a decade to replicate its current technology, by which time ASML will be way more advanced.
This is the category that’s perhaps hardest to find through inductive reasoning. Instead I would suggest you approach it deductively.
Start from the result.
Does the company have a monopoly-like position in the market?
If yes, dive deeper into the reasons and if you find that most of the resources used by the company in creating its product are available or could be available to others yet nobody can match the quality, then you may be looking at an expertise monopoly.
These are really hard to find and I would suggest you wait for them to come to you rather than actively seeking them.
7. Companies Serving “Ultra Rich”
I was going to name this category as “Ultra-Luxury Brands” then I changed my mind because I don’t think it accurately reflects the quality that I want to reflect here.
This is because most brands positioned as “ultra-luxury” don’t actually serve ultra-wealthy clients.
Take Louis-Vuitton and Burberry as examples.
They sell most of their products to the upper-middle class that considers having those products as a way to position them among the wealthy.
I am not talking about brands that cater to people who max-out their credit card limits to afford such products, I am talking about brands that serve people who don’t have credit card limits.
I am not talking about the Louis Vuitton’s of the world, I am talking about the Ferraris, Hermes, SanLonrenzos, Bugatti’s of the world…
If we give an example based on the luxury watch industry, I am not talking about even Rolex, I am talking about Patek Philippe, F.P Journe etc, though they are not public companies.
I am not talking about brands that you can afford by pushing your budget, I am talking about brands that you need to be a truly high net worth individual to afford.
The reason they tend to be exceptional businesses is very similar to toll bridges: They don’t get affected by inflation or recession.
In inflationary times, they pass all their costs, probably with some premium, to their customers and their customers don’t care. They are the people who have long forgotten reading labels.
In recessions, they are harmed way less than other businesses because virtually nobody who is about to buy a yacht forgoes it because we are having a recession.
Plus, because of this massive pricing power and insensitivity of customers to price, they can drive top-line growth at will by hiking the prices even though the organic growth flattens.
And you see them generally having high ROCE exactly for this reason. They are driving growth even when the capital employed stays the same.
For these underlying economics, they are truly a distinct breed even among the family of exceptional companies.
8. Abominations
If companies falling into one of the above categories have a high chance of being exceptional, the ones that fall into multiple categories are even more likely to be exceptional.
These are extremely rare. This is why I call them abominations.
In fact, there are only a handful of abominations we get in every few decades.
They are the ultimate exceptional businesses.
The most obvious example would again be Apple.
We have already established above that it has a very strong ecosystem. Yet, it’s also a consumer monopoly.
The iPhone, for instance, is a unique product used by more than 1.4 billion people across the world and they replace it with a new iPhone, on average, every 3-4 years.
This makes Apple an abomination.
Amazon is another obvious abomination.
It is a low cost supplier but this is not all.
Its marketplace is also a multi-sided platform. More users are on the platform, more sellers attracted which in turn broadens the selection, drives prices down and attracts even more users.
On top of all that, it has built complimentary businesses around its core e-commerce platform, becoming a giant tech ecosystem.
It’s an obvious abomination.
How do you spot abominations?
It’s impossible to do very early on because abominations weren’t born as such.
They were created to do one job and then they do it so well that they dominate that market and successfully leverage that domination to create new products and services over time.
Your best chance is that you invest in an exceptional business early on based on its current business, and then it performs so well over time that it evolves into an abomination.
Of course, you should stay with it for decades to capture all the upside.
Another option is investing in them at the times of widespread market inefficiency.
Abominations tend to stay stronger way longer after it becomes apparent that they are abominations. Because being an abomination is also self-perpetuating. It allows you to see the new opportunities early on and capitalize on them way more heavily than competitors can afford.
However, every once in a while, the market gets a correction and the prices of these abominations may fall to unreasonably low levels as we saw with META in 2022.
You should aggressively bet on abominations at those times and you’ll get most of the upside you would have gotten if you invested years before.
Overall, if a business falls in more than one category of exceptional businesses, it’s an abomination.
You shouldn’t try getting too clever to spot them early on, but once an abomination suffers an unreasonable decline, you should bet the house.
🏁Conclusion
It is possible to spot exceptional businesses by the way of observation and understanding the underlying business economics that make them exceptional.
All statistical measures like ROCE are just results of the business economics.
Once you understand the business economics, it’s easier to observe if a business has some exceptional business economics or not than by trying to make inferences from raw data.
Let me give you a categorical example here: If you look at Indian consumer electronics businesses, you will see some of them have very high ROCE.
Yet, these companies manufacture things like air conditioners, USB cables, private label digital watches etc…
These are not products that exceptional companies sell.
Yet, they have high returns on capital employed because India is just industrializing, the middle-class is growing ridiculously fast and so demand is skyrocketing.
Meaning, these companies are thriving because the demand curve is still way above the supply curve.
Are these companies printing money? Yes.
Do they have high returns on capital? Yes.
Are they exceptional? No.
They are simply riding the demand.
On the other hand, you will see that Amazon has way lower ROCE, yet it’s an amazing business. It’s investing around 20% of its revenue back in business which shrinks earnings and thus ROCE.
This is why you should start your quest of finding exceptional companies by observing the business economics, not the numbers. In most cases, it’s easier than you think and when done well, the reward is gigantic.
I tried to share my observations here but the list is not exhaustive. There are many other exceptional business economics and new ones are being invented every minute.
Just take this for the underlying message: Start with characteristics, not numbers.
Numbers tell you the past. Moats tell you the future. Exceptional breakdown!
Thanks for this, great breakdown.