Profile of the Ideal Business

A wise investor once said that a businessmen ought to begin with the end in mind and work backwards. At 10pm last night, I fired off a message that outlined my concept of “the best.” I thought I would share it below.

  1. 50-60% Gross Profit Margin – This indicates one or more proprietary aspects, often including a brand reputation and operational discipline. The margin could go higher but external threats from competitors often increase exponentially or the total addressable market becomes limited.
  2. 15-35% of Revenue to EBIT – This indicates a very well run, low overhead, low capex leader. I like comparing EBIT to gross profit when testing managers. With control of the overhead, the leader of this business has organized both his variable costs, depreciation and his SG&A very well.
  3. 15-20% Average Revenue Growth – While this might seem boring to some and super hard to others, the tension here is achieving this with a fat EBIT rate and low debt. This becomes extremely difficult as the business grows larger.
  4. 50-100% Return on Tangible Assets – This often makes possible a large return on invested capital. I also prefer ROTA to ROE or ROA because the possible organic growth rates could be higher. It also makes it clear that assembly of people and processes is more valuable than simply renting out your assets.
  5. Dividend of 5-13% of Revenue – A revenue growth rate like above, and a tangible asset load as above, makes this one achievable but difficult. Many businesses that do the upper end of this dividend rate do not get maximum growth rates like above. But, the growth is preferable because reinvestment in the existing enterprise is often safer and higher than a dividend that must find a 50-100% return in the outside world. This difference is exaggerated further if growth over the next 5 years is strong.
  6. A total addressable market 100x present revenue – Again, the market could be bigger or smaller. This is a rough ideal because it indicates you have a long time (~10 years) to grow before confrontation with a major barrier. During this time responsiveness to invested capital can be tested and adjustments made, new products or services introduced, or other. If the market is way too big, you probably will have a hard time being noticed (or it will become very expensive.)

My thoughts have matured as I have gained experience. I used to think 90%+ gross margin was best. This is not actually ideal. I also used to like 40%+ annual revenue growth rates. This too is not ideal because it often makes your balance sheet weaker, staff stressed out, or dilution to original shareholders necessary. I’ve met savvy investors that prefer fat earnings growth but are willing to eat away at the productivity capacity or lifetime value to achieve this. Peak performance holds this in tension.

I realize there are exceptions to the above, and sometimes a person can get lucky (I won’t turn that away); but the above is a challenging quality matrix to build or find. It’s also extremely stable. If a businessmen owned 3-6 unrelated companies that met the above criteria, a person would have an almost impenetrable force from which to maneuver. If he ever wanted to sell, his alternatives would most likely be worse.

The most enticing aspect regarding the above description is that this ideal is far easier to accomplish with a small net worth. Read back through it. The only size aspect worth pointing out is the relationship of total addressable market to gross profit margin. Many small businesses begin with the manager splitting his or her time in operations and hire help as they go. But, if they are mindful of this from the earliest moments, the business can be constructed and tested with just a few employees or less. This makes the overall net worth of the small businessmen an asset that cannot be duplicated. There are simply more options.

I am grateful for our portfolio. They have the bone structure to meet the above. Yet, they are not all at peak performance at the same time. As an owner and manager of a diversified portfolio this consolidated view point does provide some options however. One business might have poor growth prospects but lots of dividends. Another might have huge growth prospects but poor dividend capacity. The challenge we face is often generating the organic growth rates of the above. We have maintained it in a few, but the overall average demands we seek outside alternatives. Truly unfortunate, is it seems we always have at least one company that is bleeding and in need of repair. So goes the downside of diversification… it can become “deworsification.”

Today, our challenge is no different than what our partners faced upon joining. How do I average up the quality spectrum? We won’t flit in and out of things, but we can apply more energy into more promising enterprises. But, we must have something to aim at. Thus, the above.