Warren Buffett's 3 Questions To Help Identify Outstanding Businesses

Buffett: "This took me 25 years to learn..."

July 13, 2024

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Today, we are going to look at 3 questions Warren Buffett uses to help identify outstanding companies.

While Warren Buffett’s original strategy was buying cheap stocks regardless of the quality of the business, the late Charlie Munger persuaded Buffett to focus on quality.

Buffett and Munger both grew to believe that buying quality companies allows for greater compounding—and greater investment results:

Let’s see how Buffett helps identify high-quality businesses.

Buffett’s 3 Questions

In 1991, Buffett gave a series of lectures to students and faculty at the University of Notre Dame…

Audience members took 40 pages of notes to capture Buffett’s teachings.

Within these notes are 3 questions Buffett uses to help identify attractive businesses:

“The first question is: 'How long does the management have to think before they decide to raise prices?'

You’re looking at a marvelous business when you look in the mirror and say:

'Mirror, mirror on the wall, how much should I charge for Coke this fall?' And the mirror replies, 'More.'

That’s a great business.

When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, and say:

'Just another half-cent a yard.’

Then you get up and they [customers] say:

'We won’t pay it.'

It’s just night and day.

Buffett shared another example, from a customer perspective:

“You walk into a drugstore and say:

'I’d like a Hershey bar.'

The man says 'I don’t have any Hershey bars, but I’ve got this unmarked chocolate bar, and it’s a nickel cheaper than a Hershey bar'…

You just go across the street and buy a Hershey bar.

That is a good business.”

The lesson:

“The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.”

Let’s Visit The Racetrack

Buffett used a racetrack newspaper to illustrate his second question:

“The highest priced daily newspaper in the United States, with any circulation at all, is the Daily Racing Form. It sells about 150,000 copies a day, and it has for about 50 years, and it’s either $2.00 or $2.25 (they keep raising prices) and it’s essential.

If you’re heading to the racetrack and you’ve got a choice between betting on your wife’s birthday, and Joe’s Little Green Sheet, and the Daily Racing Form, if you’re a serious racing handicapper, you want The Form.

You can charge $2.00 for The Form, you can charge $1.50, you can charge $2.50 and people are going to buy it. It’s like selling needles to addicts, basically. It’s an essential business.

It will be an essential business five or 10 years from now. You have to decide whether horse racing will be around five or 10 years from now, and you have to decide whether there’s any way people will get their information about past performances of different horses from different sources.”

So, Buffett’s second question:

Is this an essential business?

In other words, will it be around 5 or 10 years from now?

The 25-Year Lesson

The third question is one Buffett said took him 25 years to learn:

Buffett gave the students a handout with information on 2 companies he labeled “Company A” and “Company E” (you’ll see why he called the second company “E” soon).

Company A had thousands of MBAs for employees, a strong employee benefits program (stock options, pensions, etc.), and thousands of patents. Company E had none of these things.

Company A’s product also improved dramatically while E’s product remained the same.

Naturally, you are probably heavily favoring Company A…

Then Buffett revealed the companies:

“Company A is known as company A because it was in Agony, and Company E, as Company E, because it was in Ecstasy.

Company A is AT&T…Company E…happens to be a company called Thompson Newspapers….”

AT&T “had one problem…the plant investment. …More and more money had to be tossed in, in order to make these increased earnings…

So, they got more money, but you can get more money from a savings account if you keep adding money to it every year. The progress in earnings that [AT&T] made was only achievable because they kept on shoving more money into the savings account…”

The reason Thomson Newspapers was in “ecstasy” or an excellent company:

“Once the owner bought the newspaper he never put another dime in. They just mailed money every year. And as they got more money, he bought more newspapers.”

“…he raised prices and raised earnings there every year without having to put more capital into the business.”

The lesson:

“one is a marvelous, absolutely sensational business, the other one is a terrible business...”

Which brings us to Buffett’s 3rd question:

How much capital needs to be reinvested in the business each year?

Summary

Of course, these are not ALL the factors Buffett looks for in an investment—but these 3 questions can help identify high-quality businesses.

So, let’s recap Buffett’s 3-Question Framework to evaluate the quality of a business:

  1. How long does the management have to think before they decide to raise prices?

  2. Is this an essential business? Is it going to be around 10 or 20 years from now?

  3. How much capital needs to be reinvested in the business each year?

Well, that’s it for this week.

I hope you found it valuable.

See you next Saturday.

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Disclaimers

This material is not investment advice. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading this material can be accepted by the publisher. Additional disclaimers here.