What makes a good business?

I was writing up a report this morning and it got me thinking what makes a great business. I personally search for businesses with two things: High Quality Management and a defendable Competitive Advantage. Management to me is of paramount importance as they will be executing the business plan. I think you need a team that has a strong track record and the ability to adapt to a perpetually changing environment. 

I'm curious to hear everyone's thoughts?

Comments (7)

Jan 12, 2022 - 3:02pm

Does your requirement of a strong track record mean that first time founders are relatively incapable of running/growing a good business? Just curious how you evaluate high quality management besides years in the field / previous executive positions.

Jan 12, 2022 - 3:54pm

Good question.

Most of my research (roughly 95%) focuses on established businesses. My circle of competence doesn't generally include businesses with "green" executive management. I find it difficult to assess a business's prospects without knowing management's track record running successful businesses. In saying this, the other "5%" of my research might be spent looking at businesses in their infant stages. But I have to understand the product/service really well to allocate capital to these type of investment ideas. 

Jan 12, 2022 - 4:02pm

I'd also add that my requirement when reviewing management isn't just years of service in the industry. I try assess how effective they have been at executing on their stated targets (ie. have they successfully achieved what they set out to do?). I also look at capital allocation decisions and if they added value for shareholders. These are just two decision based criteria I use in my research process. 

It's very difficult to assess a new founder if they have no prior track record. Not to say they couldn't run a successful business. I just believe that's more in the realm of PE/VC investors who have access to a wider and deeper set of resources in order to assess management at that stage.

Most Helpful
Jan 13, 2022 - 6:23am

For me, there are three primary things that I evaluate when looking for a good business: attractive industry structure and outlook, competitive advantage within that industry, and management. If you took the question a step further to what makes a good investment, the fourth pillar would be valuation, but I will keep my response limited to the business.

Industry

I put a lot of emphasis on the industry structure that the business competes in as I think that it drives a large portion of investment outcomes. Further, strong industry selection can help mitigate poor company selection and/or other idiosyncratic risks. The first thing I look for when evaluating the industry is obviously the TAM. How large can the market be? What drives demand? Is growth secular or cyclical? If cyclical, where are we likely to be in that cycle? From there I will break the industry down into four components: suppliers, competitors, buyers, and other key stakeholders (regulators, municipalities). Who has the power in this framework? Who are the major players? How aggressive is competition and what do companies compete based on? As I have become more seasoned, I have generally found that the two most important characteristics for an industry are switching costs and barriers to entry, with switching costs really being the most important thing to look for as it can be a barrier to entry in and of itself. Other sustainable barriers to entry would be minimum scale in the form of upfront investment or min volumes/unit economics and some form of network density.

TLDR: A good business has a wide and growing TAM in an industry protected by switching costs and barriers to entry

Competitive Advantage

Companies must either possess pricing power or a cost advantage in order to earn economic profits in excess of their cost of capital. What is the company's strategy? What makes this business special and allows it to earn better returns than competitors? More importantly, is the advantage structural and sustainable? There is a big difference between a competitive strength, and a sustainable competitive advantage. In my view, switching costs from high cost of failure and network effects are two of the strongest individual company advantages. I tend to have preference for companies with pricing power over companies with cost advantages as there tends to be more dynamic upside on the pricing side and cost advantages can almost always be replicated with enough time or capital. I also generally don't like companies that rely on brand power as their primary advantage. I find it harder to predict and evaluate the sustainability of a brand advantage given that it is mostly a psychological tastes and preference type of advantage.

TLDR: A good business has sustainable competitive advantages within an attractive industry

Management

I don't want to misattribute this quote, but I think Pat Dorsey has said that capital allocation is the link between business value and shareholder value. Strong capital allocation creates value on top of the value created by the business while poor capital allocation can impair value and threaten the company's moat. When evaluating management, I typically prefer to see actions that align with words. Anyone can say we do this or that, but what do they actually put capital behind? How have returns on capital inclusive of GW and Intangibles trended over time? How do they talk about their business? Is it in terms of value creation or in terms of market share and stock price? I basically want to hear management talk about their business and vision for the future the way the way that I perceive it. I also want to see them taking actions and making investments that reinforce and protect the moat. So that is part 1, part 2 is incentives. How are they paid and what types of actions does, or could, that encourage and promote? One of the scariest things to me is when a manager is comped on sales not adjusted for M&A. The incentive there is to go out and acquire sales regardless of whether it creates value. I put myself in those shoes. If someone was paying me obscene money to buy sales I would do it. Incentive alignment is very important as the incentive structure should really drive management's decisions directionally.

TLDR: A good business has a management team with strong capital allocation competency and incentives aligned with other stakeholders.

Jan 13, 2022 - 9:21am

This is a great write-up.

Reminds me of a company I am looking at right now, Adobe. Really ticks all the boxes.

They have a particularly large TAM in the core creative cloud business. One thing often overlooked by the market is the the increasing percentage of the installed base on a y/y basis that is represented by subscribers that are new additions to the Adobe franchise. Generally speaking as a business matures it would see slower growth in its mix of new subscribers, but for Adobe it has been going up. 

Strong pricing power in their creative cloud business and high switching costs as they are default tool of creative professionals. Many small and large business have tried to displace Adobe but failed.

They have one of the most impressive CEOs who has been with Adobe for over 20 years and understand the business and industry at a granular level. 

Jan 14, 2022 - 4:53am

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