What kind of business is a good business? Read on and you’ll fully understand why some companies become cash-strapped the more they grow, while others become richer and richer.
When you invest, do you ever have this question: This company looks very profitable, so why doesn’t it have much cash on its books? One of the biggest reasons is that it plows most of the money it earns back into the business—building new factories, upgrading equipment—so in the end, of course, there isn’t much left in its own pocket. That’s a typical bad business. It looks profitable, but in reality it hasn’t earned anything.
Why does this happen? In Charlie Munger’s view, a good business can keep growing with very little capital expenditure. See that? The key is capital expenditure. After a company makes money, if it has to reinvest the money it earns every year, then what it earns isn’t real silver and gold—it’s just passing through.
If a company earns 10 billion a year but capital expenditure is 9 billion, then the company is just a cash mover. It may see a lot of money, but not much of it is its own. In Munger’s words, the profit is very likely just a pile of rusty machines sitting on empty land. Conversely, if another company earns 10 billion a year but capital expenditure is less than 1 billion, leaving more than 9 billion in free cash flow, then that company’s business is a good business.
Why does Berkshire generate so much cash flow every year? Because Berkshire itself is a collection of good businesses. Berkshire’s subsidiaries, such as GEICO and See’s Candies, are all good businesses. After deducting a small amount of capital expenditure, these good businesses continuously create large amounts of cash flow.
A truly good business is one where, after the initial investment, almost no more money is needed later, yet cash flow grows year after year. Eventually, a company that owns good businesses will earn so much money it can hardly breathe. If you want to make money in investing, look for companies that are troubled because they have too much money.
The right path in investing: buy good businesses, hold them long term. Good businesses earn a lot and spend little.