Would Warren Buffett buy your business?

By Joseph McDonnell, Special to the BDN
Posted May 18, 2012, at 4:24 p.m.

The recent spike in the number of companies being purchased in Maine led me to wonder how many Maine businesses would be attractive to Warren Buffett, the well-known acquirer of businesses. Buffett turned Berkshire Hathaway, a nearly bankrupt New England textile company, into a $200 billion conglomerate by buying businesses and making long-term investments.

By looking at their own companies through the prism Buffett has successfully employed in making investment decisions, Maine’s business owners can learn a lot about the attractiveness of their companies. Buffett makes no distinction between buying a business and making an investment.

He has bought many companies in their entirety and also made long-term investments in large companies such as American Express, IBM, Wells Fargo and Coca-Cola. He uses the same criteria in making sizable investments as he uses to purchase entire companies — looking at a company’s intrinsic value and not its stock price.

Buffett looks for businesses that are simple to understand with a consistent operating history, favorable long-term prospects and management that operates like owners with an eye to increasing shareowner value. As you may recall from reading Plato in college, the Oracle of Delphi called Socrates the smartest man in Athens because he was the only one aware of his own ignorance. Like Socrates, Buffett attributes his success to knowing what he does not know. He invests in areas of his competence, looking for businesses he understands — a formula that has earned him the moniker “Oracle of Omaha.”

Buffett’s portfolio contains manufacturers, railroads, electric utilities, insurance companies and retail stores — basic businesses, ordinary and often out of fashion. They share an ability to make a product or produce a service that delivers good value to customers and a good return to its owners. Despite the extraordinary opportunities created by technological advances, Buffett has largely shunned technology companies. It’s not that he is a Luddite or lacks the intelligence to understand technology. When Buffett says he wants to invest in businesses he understands, he is saying he wants to see predictable revenue and earning streams far out into the future, something that is harder to do when rapid innovation makes products obsolete. Buffett looks at companies the way investors look at bonds — as vehicles with predictable cash flows.

Buffett recognizes that businesses must change as circumstances change, and he has great admiration for business leaders, like Lou Gerstner of IBM, who transform businesses. But he avoids investing in companies that are in the midst of change or trying to solve novel business problems, preferring stability and companies that have produced the same product or service for years. In so doing, he aims to reduce risk in his investments. He notes that change reduces predictability, which increases risk. Buffett would rather buy a stable company at a reasonable price than a troubled company at a deeply discounted price.

Buffett likes companies with solid earnings that throw off cash, which is why, despite his dislike for capital-intensive companies, he has turned late in his career to regulated companies like BNSF Railway and MidAmerican Energy. And he loves insurance companies because they give him the use of the float, the cash from premiums, to invest in productive assets.

Perhaps the distinguishing characteristic that Buffet looks for in a business is its long-term favorable prospects. He seeks businesses with franchises, which he describes as castles with wide moats because of their proprietary products or services that make it difficult for other businesses to replicate.

Buffett is a firm believer in the business adage “buy commodities and sell brands.” He looks for businesses that can convert low-cost commodities into products with high margins such as Coke, Wm. Wrigley and See’s Candies. Buffett’s investments in Coca-Cola, the Washington Post and IBM all point to companies with iconic brands and positions in the marketplace that place high hurdles for competitors to penetrate. The advantage of such franchises is that these companies have pricing flexibility, which provides a hedge on inflation because they can increase prices without losing market share. And businesses with strong franchises stand a better chance to withstand management mistakes.

Buffett buys businesses with managers who act like owners, in that they allocate capital in a way that increases shareowner value. Buffett himself models this behavior by using Berkshire’s retained earnings to buy companies that provide shareowners with a greater return than the cost of the company’s capital. He proudly notes that the companies he has purchased in the last few years are expected to produce $10 billion in earnings for Berkshire next year.

Warren Buffett may never purchase a company in Maine, but Maine companies can profit from his approach to business — keeping business models simple, building brands with differentiated products and services, and investing retained earnings to produce favorable returns for shareowners.

Joseph McDonnell is dean of the College of Management and Human Service at the University of Southern Maine, and faculty member in the Muskie School of Public Service. He formerly served as dean of the College of Business at Stony Brook University in New York, and has held executive management positions within both Fortune 500s and start-ups.

http://bangordailynews.com/2012/05/18/business/would-warren-buffett-buy-your-business/ printed on November 24, 2014