Warren Buffett first discussed the idea of a great, good and gruesome business in his 2007 shareholder letter and then I read about it again in Motilal Oswal’s 13th Wealth Creation Study. For experienced value investors this is probably a very obvious concept and deeply ingrained in their thinking but it was a particularly eye opening distinction for me when I first learned about it. Here is my attempt at explaining the distinction using a simplified example.
Imagine the following:
- You start 3 businesses, investing INR 5 lakh in each business. Each business makes a revenue of 10 lakh and profit of 1 lakh in the first year. All three businesses grow their revenue and profits at 20% every year.
- So far all the businesses are great as you’ve made a 20% return on your investment in the first year. There is nothing to choose between the businesses.
- Now assume that business 1 requires no additional investment from you every year. Business 2 requires that you invest another INR 1 lakh (maybe you need to buy a small shop to sell more products) so that you can achieve 20% revenue and profit growth. Business 3 requires you to make an investment of INR 5 lakh (maybe you need to invest in a new factory) to achieve the growth numbers.
- Which business will you like now?
- Of course business 1 is amazing. At no additional investment you are getting additional INR 20,000 of profits, making the return on your original investment 24% (1.2 lakh/5lakh).
- Business 2 is pretty good too. You invest an additional 1 lakh and you make additional profits of INR 20,000, which gives you a 20% return on your additional investment.
- Business 3 doesn’t look very good. You invest INR 5 lakh but make additional profits of only INR 20,000, giving you a paltry 4% return on your additional investments.
This simplified example demonstrates the difference between a great, good and gruesome business. Even though the growth rates in revenue and profits are identical between the companies,
- Business 1 is Great – it grows profits without any additional capital requirement from the owner
- Business 2 is Good – it requires a moderate amount of additional capital and the return on this additional capital is quite good
- Business 3 is Gruesome – it requires a large amount of capital to achieve its growth and delivers a small return on the additional capital that is invested
In the stock market, companies like Business 1 and 2 create value for shareholders where as companies like Business 3 will repeatedly destroy value.
A great business is one that may grow at modest rates but requires almost no additional debt or equity capital to grow its business. These businesses are protected by moats (or long term competitive advantages such as a strong brand or low cost production) that prevent competitors from stealing their business or driving returns down. Tech companies like Google fall in this category. In India, HUL is often cited as an example of a great business. These businesses are protected by strong moats and require minimal investments (in plants or machinery) to grow their business.
A good business is one that can grow at a healthy pace but requires capital investments to achieve this growth. A good business still needs to have some competitive advantages so that the returns on the additional invested capital are maintained. I think Balkrishna Industries is an example of a good business.
A gruesome business is best described by Buffett himself. “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.” Often entire industries can be characterised as gruesome. Airlines and Telecom are often cited as examples of gruesome industries.
As investors we often get allured with rapid growth in revenues in profits. But we need to remember that we invest in companies for cashflows and not profits. We always need to ask how much additional capital will the business need to achieve its growth rates and what will be the rate of return on the additional capital that is invested? After making these investments, will the company have any free cashflows remaining to return back to shareholders?
Motilal Oswal’s 13th Wealth Creation study has a good rule of thumb to follow:
“Buy ‘Good’ companies at great (bargain) prices or buy ‘Great’ companies at good (reasonable) price.”
“Gruesome companies are best avoided, whatever the price!”
Key Questions for Investors
After learning this concept, the questions that I always ask myself when analysing a stock/industry are:
- What are the Free Cashflows of the company (not just earnings)?
- How much additional capital will the company need to grow?
- What is the capital efficiency of the company (ROE, ROCE, ROTCE)? Is it likely to sustain?
- What is the moat or durable competitive advantage of the company (a question deeply linked with the one above)?