in Berkshire Hathaway, Brent Beshore, Charlie Munger, Constellation Software, investment criteria, Mark Leonard, niche, Permanent Equity, return on equity, Sherlock Holmes, Warren Buffett

Analysis of Investment Criteria

“The world is full of obvious things which nobody by any chance ever observes.”

Sherlock Holmes in The Hound of the Baskervilles, Conan Doyle

Maybe it’s signalling, maybe it’s marketing, maybe it’s self-selection, but I have long found fascinating what the greatest investors look when making investment decisions. The best investments can be whole businesses (i.e. acquisitions and/or mergers) but as Mr. Buffett has said, he’ll buy part interests in great businesses whenever the opportunities present themselves.

There’s a tonne of books out there on investing — lots of heuristics and lots of opinion. What I haven’t found analysts focus on a (deep) analysis of what and why great investors choose what they do when they buy the entirety of a business. If investments are great in whole or in part then using the same criteria, I suspect, would be a great place to start compiling the ultimate investment criteria. I also suspect that buying whole private businesses is the same criteria that Mr. Buffett uses to buy part public businesses (and I think he’s said as much in many of his shareholder letters. Though of course there are nuances there.)

Let’s start digging.

Berkshire Hathaway (BRK)

It might as well be that we start at the very beginning.

Mr. Buffett and Charlie Munger at Berkshire has always been pretty upfront about their investment criteria and the earliest mention (publicly and succinctly) is from the annual report in 1996.

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria: 
Large purchases (at least $50 million of before-tax earnings),

– Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations), 
– Businesses earning good returns on equity while employing little or no debt
Management in place (we can’t supply it),
Simple businesses (if there’s lots of technology, we won’t understand it),
An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

Berkshire Hathaway’s Acquisition Criteria, Annual Report 1996

(Here’s a fun fact: if you change the URL in the link above and just change the year from 1996 to 1999 you’ll see the published acquisition criteria from all each year!)

Taking aside the size (in 1996 it was 50m before-tax earnings and how they are looking for deals in the ‘B’s), and also the non-monetary aspects (not interested unfriendly takeovers), this is a very simple list to work with. Let’s also take out the price because that’s somewhat a given in the public markets (i.e. the manic Mr. Market who throws out crazy prices from day to day).

In laymen’s terms this is what Buffett and Munger are looking for: history of profits, history of good returns on the money employed, good/great operators, prefer less complex businesses.

Now let’s check out there places.

Permanent Capital (PermC)

Brent Beshore’s Permanent Capital is operating maybe where Berkshire was in the very early innings, but also has published their own version of self-screening for would-be acquirees.

Here’s the current list of Permanent Capital’s Acquisition Criteria:

We look for North American-based private companies with consistent annual pre-tax net earnings between $2.5 million and $15 million, and two or more of the following characteristics:

Stable & Diversified Client Base
– Healthy Layer of Non-Owner Management
– Closely Held Ownership Looking to Retire
Quality Brand Name/Strong Reputation
– Established Niche Expertise

Permanent Capital’s Acquisition Criteria

Again, ignoring the deal size, they’re looking for companies with consistent profitability, not too much customer concentration, businesses that are entirely dependent on client-relationships as the majority of their assets, looking for succession (for full ownership and for controlling ownership), quality and niche.

What’s interesting is that Beshore is actually saying it’s fine that you have maybe just 2 of any of these, certainly the more the merrier, but that 2 is enough to be interested.

Consistent. Pre-tax earnings. Seems obvious.

So far, neither of these have explicitly signalled the use of price to earnings ratios. Certainly you know it when you see it and do some due diligence. Though Buffett does call out good returns on equity.

Let’s venture wider.

Constellation Software (CSU)

Another serial acquirer (of sorts), Mark Leonard has perfected his craft of finding great small vertical market software businesses.

What different about Leonard’s criteria is that they explicitly break out what is their hierarchy of exceptional businesses versus what are good businesses that they’d still be interested in.

Let’s start with the good businesses first.

Here’s Constellation Software’s acquisition criteria of good businesses:

“We are pleased to hear from principals or representatives of Good Businesses that meet the following criteria:

Number 1 or Number 2 market-share holder in a niche vertical market
– Revenues of at least $5-million
Hundreds or thousands (not dozens) of customers
Unimposing competitors
– An offering price that has been determined”

Constellation Software’s Acquisition Criteria for “Good Businesses”

Here we see similarities between Permanent Capital and Constellation Software.

Niche. Lack of customer concentration.

It’s also interesting to see that having a leader position in the niche industry is important. Figures that the leader might be winner-take-all or have a commanding lead that others in the software business have a harder time in catching up to.

First time I’ve seen competition mentioned. Harder to pre-determine and/or quantify that as an acquirer and or acquiree, in my opinion. Or rather it’s easy to position one’s business as anywhere in a wide spectrum in the marketplace.

Now let’s look at their criteria what is exceptional.

We are pleased to hear from principals or representatives of Exceptional Businesses that meet the following criteria:

– A mid- to large-sized vertical market software company (a minimum of $1-million earnings before interest and tax)
Consistent earnings and growth — generally EBITDA/revenue + revenue growth of 20 percent or more per year
Experienced and committed management
– An offering price that has been determined

Constellation Software’s Acquisition Criteria for “Exceptional Businesses”

This is an even shorter list!

Taking size and price out (once again), we’re just left with the consistency earnings part. This time growth is explicitly mentioned and the metric used is EBITDA/revenue + revenue growth > 20% per annum.

How interesting is that.

I’ll probably stop here and I’ll add more criteria I’ve seen elsewhere from debt providers to private equity.

So far the “string” that flows through these incredible value creators who have made their mark by buying whole and part businesses are the following:

  • History of Consistent Pre-tax Earnings (BRK, PermC, CSU)
  • Niche Business (PermC, CSU)
  • Free from Customer Concentration (PermC, CSU)

To a smaller degree:

  • Good Returns on Equity (BRK)
  • Consistent Growth (CSU)
  • Free from Ownership Concentration (PermC)

Now you have it.