By Barry Schwartz
Warren Buffett has said many times, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." But what is a wonderful company? Isn't wonder in the eye of the beholder? Can one assess a wonderful business on a quantitative basis?
One quantitative measure that many investors use to determine if a company is wonderful is its Return on Equity (ROE). This is a measure of how well a company is doing with the money that it currently has. The higher the percentage, the better off the company has performed. If you look at a list of Buffett's holdings over the years, you will see that many of the stocks that he has owned have had very high ROE percentages. The ROE is one measuring stick that we use in our shop to screen or identify potential investments. But this formula is backward looking. It tells us how profitable a company was. What if we want to figure out how profitable a company will be in the future?
Even the Oracle of Omaha cannot predict the future but if you were to use one formula to figure out how well a company will do with further capital, you would screen for companies with a high Return on Capital (ROC) along with a high ROE. A company that can grow its business at a higher rate for less capital is obviously a better business than a company that needs a lot of capital for growth.
For example, we believe Visa (NYSE:V) is a wonderful business. The company operates a toll-road on the credit card highway. Its ROE is high at around 18% and its ROC is remarkably high at over 20%. Percentages are fine but let's talk absolutes. In the six months ending March 31, 2014, Visa's revenues and profits increased by $500M each. But what sets Visa apart as a wonderful company is it was able to post these numbers with an increase to its capital expenditures of only $6 million more than the previous six months. This is stunning. With next to no extra capital invested in its business, year over year, Visa grew its operating profit by 13%. Visa took on no debt and no equity to grow its business over the past six months or any year since it has gone public. As the network of its customers grow around the world and as more people use credit and debit cards instead of cash, it's easy to see that Visa won't need any additional capital for organic growth for a long time. As a result, Visa generates oodles of excess cash, which it has used every year to repurchase shares and increase its dividend. This is wonderful.
Visa's valuation is no bargain. At a valuation of over 20 times its expected earnings this year, you are paying a high price for a wonderful business. We think a recent correction in its share price represents a decent entry point and have started to accumulate shares for all clients. Warren Buffett, you get the final words:
"If you own a wonderful business… the best thing to do is keep it. All you're going to do is trade your wonderful business for a whole bunch of cash, which isn't as good as the business, and you got the problem of investing in other businesses, and you probably paid a tax in between. So my advice to anybody who owns a wonderful business is keep it."
Disclosure: The author and clients of Baskin Financial Services Inc. own shares in Visa.