The following few paragraphs originally were part of another post still under construction but they hurt its flow and somehow seemed out of place in their self-containedness, so I am putting them here. Hopefully you will find them of interest.
What makes a good Business
An outstanding business rests on a foundation of two equally indispensable pillars. One is the intrinsic nature of its operations, the other is its management and employees. Let me elaborate a little bit on what I mean by that.
The nature or structure of operations fundamentally makes the organization what it is as such. You would not call the postal service a postal service if it primarily sold limbless cold-blooded vertebrates with gills, now would you? At that point you would call it a large-scale distributor of fish and various other goods or perhaps you would refer to it as ‘the sodding reason why my mail reeks of halibut’.
Clearly an organization will take on the characteristics of its underlying operations and behave accordingly. If for a prolonged period of time it does not, then either you have misunderstood its primary activity (maybe the umbrella-retailer whose sales-volume is uncorrelated with the weather is not really selling classic umbrellas but a status-symbol made desirable by ingenious marketing and therefore more suitably categorized as a luxury/lifestyle brand) or there is some fishiness (Herbalife anyone?) going on.
But classification issues aside, any organization is ultimately limited by the characteristics of its operations. If what a business offers is at its core broken, already available in sufficient quantities or unattractive (be it because of inefficient production, it simply not adding value to the customer’s life or a combination thereof) the venture in its entirety will not be a good long-term investment. A pyramid or Ponzi scheme (or simply a terrible business) for instance must collapse eventually, on the very simple basis that its activities do not add net value. Yes, purchasing power shifts from one party to another but the system as a whole is endothermic and needs constant external input to be sustained and be able to grow. A real business’ operations on the other hand behave exothermically, meaning that even without constant outside financing it can sustain and potentially grow itself. An attractive operation is able to sustainably fuel itself from internal cash-flows. Zero exceptions. This is one of the pillars.
The other supporting element is of course people (how anthropocentric) – that is management & employees. They are who is responsible for the optimization of the metrics of underlying operations (no matter if their characteristics are awful, great or somewhere in-between). The management itself cannot change the natural dynamics of a business or industry beyond pushing the enterprise to be as efficient as possible. Good management can however recognize if an operation is attractive in the long-term and adapt depending on the verdict by expanding in terms of scale, commencing a different type of operation entirely, terminating an unattractive operation or enacting an appropriate mix of these measures. Warren Buffett’s acquisition and subsequent transformation away from textiles of Berkshire Hathaway is an example of excellent management and its limits. Even the leadership at Berkshire could not mitigate the problems of the coeval textile industry (reliant on continuous heavy investment, very volatile demand, requiring trained labor in fluctuating numbers) to a sufficient degree and so the only correct choice was to attempt an ordered retreat to greener pastures such as insurance – which obviously succeeded spectacularly. Still, even Warren Buffett could not avoid terminating unattractive operations in the long-term. Management results are totally dependent on operations. Thus a company’s unsatisfactory performance in the short-term does not necessarily indicate bad management or staff but bad long-term results decidedly do. This is the other hallmark of an excellent business: Good management over time reduces unattractive operations of a business and increases attractive ones.
Next time you are struggling to decide if a company is a great enterprise, look at the two pillars. If either one is missing you have your answer.
Tom
The Financial Flâneur 