Buffett’s Favorite Type Of Company
Contents
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INTRO
When it comes down to it, there's really only one thing that truly matters in business - cash flow. I’ve never seen a business go bust because of strong cash flows. But some companies certainly have gone bankrupt and out of business when the money ran out.
Yet, many new investors still fixate on earnings instead of cash flow. And as a consequence, they end up picking mediocre stocks. Learn more about cash flow and Apple's excess cash pile in our previous write-up here: Apple's Cash Management.
As Warren Buffett constantly emphasizes, it is wise to understand the business in which you are investing. A big part of that entails a solid understanding of the finances of any such businesses. Falling under the tutelage of legendary investor, Philip Fisher, Buffett learned that an essential step in shrewd investing is to learn as much about a prospective company as possible, from publicly available resources but also, if possible from anyone directly familiar with the company.
Buffett's business tenets when eyeing a prospective investment focus on 3 main areas:
1. A business must be simple and understandable
2. A business must have a consistent operating history
3. A business must have favorable long-term prospects
To be clear: have solid knowledge of any business you invest in and how much cash it produces.
At a broad level, we can classify businesses into two types:
A. High-capital intensive
B. Low-capital intensive
Businesses that are capital intensive and require high levels of capital investment negatively impact cash flow.
Let's take Ford, for example. They need to develop and maintain very costly factories, production lines, and other high-priced equipment and fixed assets. A company like Microsoft, on the other hand, only needs an office, grade-A personnel, and a low-cost tech infrastructure.
Let’s look at these two types of businesses a bit more.
High-Capital Intensive Stocks
Highly capital-intensive businesses need a lot of money for infrastructure, equipment, and facilities to run smoothly.
Because they have to keep investing in these things on a regular basis (called CapEx, or capital expenditures), these investments eat into their free cash flow. This means a big chunk of their profits go right back into simply maintaining the business instead of being available for strategic moves like market expansion, new product development, acquisitions, or distributing such funds to shareholders via dividends or share repurchases.
So, these sort of companies can't expand as quickly as businesses that don't need so much upfront investment.
Here are a few examples:
· Boeing Company (BA) - Aerospace and defense manufacturer
· Exxon Mobil Corporation (XOM) - Oil and gas exploration and production
· Intel Corporation (INTC) - Semiconductor manufacturing
· Southern Company (SO) - Electric utility provider
To be fully honest, you can’t expect much in terms of return on investment from these stocks. Part of the reason is the enormous outlays in capital expenditures.
Now, let’s look at the second group.
Low-Capital Intensive Stocks
Low-capital intensive businesses don't need as much money upfront for their operations. They typically require minimal investment in physical assets like factories and equipment. This means they have more free cash flow (FCF) available because they don't have to constantly reinvest a large portion of their earnings into maintaining or expanding infrastructure.
As a result, these businesses can scale more quickly and efficiently compared to their capital-intensive counterparts.
For instance, companies like Microsoft thrive with relatively modest investments in office space and tech infrastructure compared to industries like automotive or heavy
manufacturing.
Here are a few examples:
· Microsoft Corporation (MSFT) - Software and cloud computing leader.
· Alphabet Inc. (GOOGL) - Parent company of Google, dominating online search and advertising.
· Hilton Worldwide Holdings (HLT) - a low-asset provider of hospitality and hotels. It leverages its portfolio of brands via franchises.
· Starbucks Corporation (SBUX) - Global coffeehouse chain and coffee company.
Now this where the big money lies.
Buffett’s Favorite Type
Buffett favors low-capital intensive companies because they generate substantial excess cash, which can be reinvested in growth or returned to shareholders.
As we know, it's preferrable to favor companies with a long-term, durable competitive advantage. A business with a competitive advantage must be able to sustain that competitive advantage well into the future without having to expend huge sums of capital to maintain it.
Having a low-cost competitive advantage is critical for 2 reasons:
1. Predictability of earnings power
2. Enhancing shareholder value
As reiterated in this write-up by Schiff Sovereign : "Buffett spent decades buying wonderful businesses that were profit machines, yet required very little capital investment."
If the company can keep producing products that are in high demand by consumers year after year, it's very likely that it will continue to do so well into the future despite any short-term bad-news event, and despite any economic hiccups.
As consumer demand persists, the company remains ready and able to provide its products without having to spend large sums of capital to do so. A company with predictable earnings power provides a solid long-term investment prospect.
Additionally, low-cost durability allows the company to use superior earnings from its competitive advantage to expand shareholders' fortunes via dividends, share repurchases, and reinvestment into operations at above-average returns, rather than using that capital to remain afloat.
Given the choice between Ford and Microsoft, he would undoubtedly opt for Microsoft. And you can clearly see what’s happening to their Free Cash Flow.
Conclusion
Remember, when evaluating prospective investment opportunities, be sure to prioritize companies that are low-capital intensive. Evaluate the balance sheet to determine the CapEx (capital expenditure) needs for operations. Even if such expenditures are only made every few years, they will certainly have an effect on cash flows.
While it can be somewhat concealed via reported GAAP earnings, CapEx certainly impacts cash flow. Businesses that are capital intensive and require high levels of capital investment can adversely impact cash flow trends. And the ability to consistently generate strong cash flows will allow companies with excellent business economics to sustain their competitive advantage.
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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.
