How to Identify a Great Business for Long-Term Investment

When Warren Buffett and Charlie Munger speak about investing, their wisdom often centers on finding and holding exceptional businesses forever. 

1. Free Cash Flow Generation

A cornerstone of any successful business is its ability to generate free cash flow (FCF). Unlike earnings, which can be influenced by accounting choices, FCF provides a clear picture of a company's financial health and its ability to sustain itself without relying on external funding. FCF represents the cash left over after covering operational expenses and necessary investments, offering a transparent view of how well a company can thrive independently.

Consistently strong free cash flow allows a business to navigate economic downturns, capitalize on growth opportunities, and deliver value to shareholders through dividends, share buybacks, or by retaining earnings to compound growth and increase long-term value.

At Berkshire Hathaway's annual meetings, Munger often critiques businesses that require constant reinvestment just to stay afloat, as they struggle to grow profits or reward shareholders. He advocates for companies that generate sufficient free cash flow without needing excessive capital reinvestment, ensuring they can not only maintain operations but also grow and return capital to shareholders.

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested—there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business." Charlie Munger

2. High Return on Capital and Reinvestment Ability

Another key principle is the company's ability to generate high returns on the capital it employs. This metric shows how well a company is using its resources to generate profit. The most attractive businesses for long-term investors are those that can earn significantly more on their invested capital than their cost of capital.

What’s even better is when the company can reinvest those profits into its business at similarly high rates of return. This is the holy grail of compounding, where each dollar invested by the company produces several dollars in future earnings. 

Munger has long emphasized that good businesses "reinvest in their operations and earn even more money, like rolling a snowball downhill." The companies that master this principle create long-lasting value for shareholders.

3. Moat

A company with a strong market position often benefits from a durable "moat"—a set of competitive advantages that protect it from rivals. These advantages can come from economies of scale, network effects, brand loyalty, or even regulatory barriers, all of which allow a company to outperform competitors over the long term.

One of the most powerful aspects of a strong moat is pricing power—the ability to raise prices without losing customers. As Charlie Munger has pointed out, “There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. That is the ultimate no-brainer.”

Munger provided examples such as Disney, which discovered it could raise prices at its theme parks and for video cassette sales without affecting demand, and See's Candies, where Munger and Warren Buffett increased prices faster than others might have, leveraging strong brand loyalty. Similarly, Coca-Cola, another Berkshire investment, had untapped pricing power that enhanced profitability, coupled with excellent management that further maximized its potential.

Companies with this kind of pricing power can increase profitability without needing to grow sales volume, solidifying their market position and boosting long-term success. 

4. Strong Balance Sheet

Financial strength is a core criterion for long-term investors. We look for businesses with strong balance sheets, meaning the company has minimal debt relative to its equity and cash reserves. A robust balance sheet not only shields a company from economic downturns, but also provides the flexibility to seize growth opportunities or return value to shareholders without relying on external financing.

5. High Barriers to Entry

Lastly, great businesses are often protected by high barriers to entry. These barriers prevent new competitors from easily entering the market and eroding a company's market share. Companies with high barriers to entry enjoy long-term competitive advantages, which protect their profitability and market position.

These barriers can come in many forms: brand loyalty, patents, economies of scale, regulatory advantages, or even proprietary technology.

A perfect example of high barriers to entry is Google's dominance in the search engine market. Despite efforts from major competitors like Apple, Microsoft, and other tech giants with vast resources and ecosystems, Google's market share remains around 90%.