Warren Buffett's Co-Pilot Loves This Kind of Company

By Markets Fool.com

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Charlie Munger is Warren Buffett's co-pilot and one of the brightest investing minds ever. Munger believes investors should focus on high-quality companies and hold them for the long term, and he clearly knows what he's talking about. Let's take a look at some of what Munger has said and some companies that might fit his criteria.

Why quality matters

To some degree, business quality is in the eye of the beholder, and there are many aspects to consider when analyzing a company's quality. However, one of the most unmistakable traits of a high-quality business is its ability to sustain elevated returns on capital over the long term. The higher the returns a company can make on its capital, the higher the gains investors can expect over the years.

In Munger's own words:

We have really made the money out of high-quality businesses. In some cases, we just bought the whole businesses. And in some cases, we just bought a big block of stock. But when you analyzed what happened, the big money has been made in the high-quality businesses.

Over the long term, it is hard for a stock to earn a much better return than the business which underlies its earnings. If the business earns 6% on capital over 40 years and you hold it for 40 years, you are not going to make much different than a 6% return, even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you end up with one hell of a result.

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There are different ways to measure return on capital. Investors can focus on return on equity (ROE) or they can use a wider measure such as return on invested capital (ROIC). Leaving mathematical considerations aside, it's of the utmost importance to understand the main drivers behind elevated returns of capital and, above all, the sustainability of those factors.

In a free-market economy, success attracts competition, so when a company is making above-average returns, other industry players try to steal away a share of those returns. That's why investors need to pay close attention to a company's competitive strengths, meaning the factors that allow it keep the competition at bay, protecting its markets and profit margins. In Buffett's language, we're talking about a company's "moat."

Brand power can help fill a moat. Let's look at a few companies with strong brands.

Powerful brands for superior returns

Brand power is an extraordinary source of competitive differentiation, and it can make all the difference in the world for companies in the consumer sector. When a company owns a valuable brand, customers are willing to pay more than they would for similar products from the competition, with obvious implications in terms of profitability and return on capital.

Apple (NASDAQ: AAPL) is a textbook example. According to a Forbes brand ranking, Apple is the most valuable brand in the world. In addition to brand value, Apple offers a sticky ecosystem of software, services, and applications embedded in its devices, and customers are notoriously loyal to the company.

Most industry players in consumer electronics struggle to make money, but Apple is the exception to the rule. According to data from Morningstar, Apple generated a ROE ratio around 37.9% over the past 12 months, while the ROIC ratio stands at nearly 23.5%.

Nike (NYSE: NKE) is another high-quality business generating strong returns on capital thanks to its powerful brand. The Nike swoosh is one of the most recognized logos in the world, and the company has invested massive amounts of money into sponsoring the most renowned athletes in various sport disciplines. That commitment has made the company the undisputed heavyweight champion in sports shoes and apparel on a global scale.

In addition to brand differentiation, scale advantages and a massive distribution network provide extra layers of competitive strength for Nike, and the company enjoys a ROE ratio of 30.1% and a ROIC ratio in the area of 26.6%.

With almost 24,400 stores in 74 countries, Starbucks (NASDAQ: SBUX) is building a global coffee emporium, and management is still finding new opportunities for profitable expansion, especially in emerging markets such as China. The company has nearly 2,300 stores in 100 Chinese cities, and it's planning to open 500 new stores per year in the country over the coming five years.

Starbucks is all about providing a differentiated customer experience, and the brand is associated with quality and a very particular cultural footprint. Even if Starbucks charges higher prices than the competition, customers don't seem to mind paying a few extra bucks. Thanks to these strengths, Starbucks makes an impressive ROE ratio of 46.11%, while the company's ROIC ratio is around 29.3%.

There is no infallible formula to picking winning stocks, but names such as Apple, Nike, and Starbucks look well-positioned to continue delivering above-average returns on capital in the years ahead. And I agree with Munger that that's something we should look for when picking stocks.

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Andrs Cardenal owns shares of Apple. The Motley Fool owns shares of and recommends Apple, Nike, and Starbucks. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.