"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." - Warren Buffett
The Oracle of Omaha has amassed a fortune investing in so-called "wonderful" businesses. But what exactly makes a business "wonderful"?
That is debatable, but one of the most important factors for Buffett is a durable competitive advantage, or "moat". That's because it is a company's competitive advantage that allows it to earn excess returns for its owners.
Quantifying Moats
One of the best ways to quantify whether or not a business has a durable competitive advantage is to measure its return on invested capital.
Return on Invested Capital (ROIC) is calculated as:
Net Operating Profit After Taxes / Invested Capital
An ROIC of 15% means that for every $1 of capital invested in a business, 15 cents of after-tax income was created during that period.
The best companies consistently generate returns greater than their weighted average cost of capital (WACC). The weighted average cost of capital for a company is the minimum return required to satisfy all investors, including creditors and shareholders.
Companies that generate ROIC above their WACC are creating value by earning returns above what the market requires for assuming the risk of investing in the company. This is known as positive economic profits.
Naturally, if a company or an entire industry is consistently generating positive economic profits, then it will attract some competition. A truly wonderful business will be able to fend off this competition and sustain those excess returns. So a wonderful business should not only have a high ROIC, it should have stable or growing ROIC over time too.
3 Wonderful Businesses at Reasonable Prices
So what are some wonderful business trading at reasonable prices right now?
I ran a screen using Research Wizard that looked for the following criteria:
- Average returns on invested capital > 12% over the last 5 years
- Current return on invested capital > its 5-year average
- Price / forward earnings
- Price / cash flow
I filtered further for companies with a long history of strong sales and earnings growth with solid, and improving, profit margins that are not highly leveraged using the following additional criteria:
- Average sales growth > 10% over the last 5 years
- Average EPS growth > 10% over the last 5 years
- Average operating profit margin > 10% over the last 5 years
- Current operating profit margin > its 5-year average
- Debt / total capital
Here are 3 of the top names from the list.
- Fossil Group Inc (NASDAQ:FOSL)
ROIC (TTM): 24.1%
5-yr Average ROIC: 23.1%
Forward P/E: 14.2
P/CF: 13.1
Fossil primarily makes and sells watches through both proprietary and licensed brands, but it also sells other consumer fashion accessories, including jewelry, handbags and small leather goods. It's affordable luxury items resonate with consumers, both domestic and abroad.
- Copa Holdings SA (NYSE:CPA)
ROIC (TTM): 17.7%
5-yr Average ROIC: 14.7%
Forward P/E: 11.8
P/CF: 10.5
Copa Holdings is the holding company for Copa Airlines and Copa Airlines Colombia, which are premier Latin American airlines. Unlike most airlines, Copa has managed to deliver consistently strong returns on invested capital over time thanks in part to its strategically-located hub in Panama City and focus on low operating costs and efficiency.
- Gentex Corporation (NASDAQ:GNTX)
ROIC (TTM): 16.5%
5-yr Average ROIC: 14.7%
Forward P/E: 15.0
P/CF: 14.7
Gentex primarily designs and manufactures automatic-dimming rearview mirrors and electronics for the global automotive industry. These mirrors utilize proprietary electrochromic technology to dim in proportion to the amount of headlight glare from trailing vehicle headlamps. This differentiation has led to wide profit margins, strong cash flow and a conservative balance sheet for Gentex relative to its industry.
The Bottom Line
A wonderful business is one that consistently generates positive economic profits for its owners. These three companies have done just that, and each currently trades at reasonable prices.
Disclosure: The author owns shares of Copa Holdings (CPA).
Todd Bunton, CFA is the Growth & Income Stock Strategist for Zacks Investment Research and Editor of the Income Plus Investor service.