Buffet's Investing Spectrum

In the ever-evolving world of finance, spotting the right kind of business to invest in can be a game-changer. Warren Buffett, the OG of investing, has dropped some timeless gems in his annual letters to shareholders. One standout moment came in 2007 when he broke down the types of businesses into three categories: exceptional, solid, and risky. Even today, this breakdown serves as a crucial guide for anyone looking to make smart moves in the market.

The Exceptional: Businesses with a Built-In Superpower

When Buffett talks about "exceptional" businesses, he’s referring to companies that have a built-in superpower—a strong competitive edge, or "moat." This moat is what keeps competitors at bay, allowing these companies to consistently rake in high profits.

Buffett puts it like this: "A truly exceptional business must have a durable moat that safeguards excellent returns on invested capital. The forces of capitalism ensure that competitors will constantly challenge any business that is earning high returns. Therefore, a strong barrier such as a company’s being the low-cost producer (GEICO, Costco) or having a powerful global brand (Coca-Cola, Gillette, American Express) is essential for long-term success."

These companies are like the Marvel superheroes of the business world—they thrive in stable industries and don’t need constant reinvention or superstar managers to stay on top. A prime example is See’s Candies, one of Buffett’s favorite investments. It doesn’t grow fast, but its high returns on capital mean it doesn’t need much reinvestment. This leaves plenty of cash to invest in other profitable ventures, creating a virtuous cycle of wealth creation.

The Solid: Reliable but Demanding

Not every company can be exceptional, but that doesn’t mean you should write them off. "Solid" businesses are those that can still bring in good returns, though they often require more cash to keep the engine running. These companies might have a competitive advantage, but they’re usually in sectors that demand significant reinvestment to maintain or boost earnings.

Buffett describes solid businesses as those that "need significant increases in capital to drive their growth." While these companies can be profitable, their economics aren’t as favorable as the exceptional ones. In other words, they need continuous reinvestment to keep the good times rolling, which can eat into your returns as an investor.

Take FlightSafety, a flight training company, as an example. It’s got a strong market position but also needs hefty capital to grow. It’s a good business, but it’s not going to deliver the same level of returns as an exceptional one. Over time, solid companies can make you money, but they’re more demanding in terms of the capital they require.

The Risky: Money Pits in Disguise

Then, there are the "risky" businesses—the ones you should dodge like a bad meme. These companies eat up tons of cash but give little in return. They might grow fast and look flashy, but they require huge investments just to keep going, and they often fail to generate real profits.

Buffett doesn’t mince words when talking about these businesses. "The worst sort of business is one that grows rapidly, requires significant capital to fuel the growth, and then earns little or no money," he says. The airline industry is his go-to example of a risky business. Despite its constant need for capital, it’s a sector that has historically disappointed investors with low returns.

Buffett even shares his own cautionary tale. Berkshire Hathaway’s investment in US Air preferred stock seemed promising at first, but the company quickly hit turbulence. Although they eventually sold the shares for a profit, US Air went bankrupt twice in the decade that followed—a clear example of why risky businesses can be a trap.

Conclusion: The Key to Smart Investing

Warren Buffett’s advice boils down to this: Focus on two things when evaluating a company—return on capital and the need for reinvestment. The ideal company gives you high returns without demanding much reinvestment. If a company needs a lot of reinvestment but still offers strong returns, it can still be worth your time. But if both returns and reinvestment are low, it’s a no-go.

Buffett sums it up with a simple analogy: "Think of three types of ‘savings accounts.’ The exceptional one pays an extraordinarily high interest rate that will increase over time. The solid one offers a decent rate of interest that will apply to additional deposits. Finally, the risky account pays a low interest rate and requires you to keep adding money at those disappointing returns."

Understanding these differences can help you make smarter investment choices, focusing on businesses that are more likely to succeed while avoiding those that could drain your resources.

References

1. https://www.berkshirehathaway.com/letters/2007ltr.pdf

2. https://berkshirehathaway.com/letters/2023ltr.pdf

3. https://www.fincart.com/blog/warren-buffett-annual-letters-to-shareholders/

4. https://www.fool.com/investing/how-to-invest/famous-investors/warren-buffett-investments/

5. https://economictimes.indiatimes.com/markets/stocks/unlock-stock-market-success-time-tested-lessons-from-warren-buffett-the-invincible-investment-icon/articleshow/110897693.cms?from=mdr

6. https://www.valuewalk.com/the-cult-of-warren-buffett/