INVESTING IN SUPERIOR SERVICE COMPANIES

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INVESTING IN SUPERIOR SERVICE COMPANIES

In Mary Buffett's 1997 book called Buffettology, she outlines nine questions she believes her former father-in-law, Warren Buffett ponders before making an investment decision...

Does the business have an identifiable consumer monopoly?
Are the earnings of the company strong and showing an upward trend?
Is the company conservatively financed?
Does the business consistently earn a high rate of return on shareholders' equity?
Does the business get to retain its earnings?
How much does the business have to spend on maintaining current operations?
Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?
Is the company free to adjust prices to inflation?
Will the value added by retained earnings increase the market value of the company?

The first question is the most important. Buffett truly loves consumer monopolies. Such status is typically attached to companies like Coca-Cola and Gillette, which make products that every retail shop must stock in order to meet consumer expectations. If a company's product is a brand name you immediately recognize, the odds favor there being some kind of consumer monopoly at work.

Companies that provide services that constitute consumer monopolies are much harder to identify. American Express was one such investment for Warren Buffett-- a consumer monopoly offering financial services such as credit cards. But admittedly, consumer monopoly service businesses are harder to identify than product manufacturing monopolies.

Businesses That Provide Repetitive Consumer Services

Warren Buffett prefers businesses that provide repetitive consumer services that people and businesses are consistently in need of. Not products, but services. Ideally, these services can even be supplied by semi-skilled workers. Some Buffettology examples of such service businesses are ServiceMaster, which provides pest control, professional cleaning, maid services, and lawn care; Rollins, which runs Orkin, the world's largest pest and termite control service, and also provides security services to homes and businesses; and H&R Block, which helps Americans fill out their overly complex tax returns. Because they require little capital investment for equipment or buildings, they all achieve very high returns on equity.

The key to these companies is that they provide necessary services but require little in the way of capital expenditures or a highly paid, educated workforce. Additonally, there is no such thing as product obsolescence or even inventory. Once the management and infrastructure are in place, the company can hire and fire employees as the work demand dictates. You hire a person to work as a security guard for $8 an hour, give him a few hours of training, and then rent him out at $25 an hour. When there is no work, you don't have to pay him.

Also, no one has to spend huge amounts of money and energy on upgrading or developing new products or aging equipment and factory buildings. The money generated by such service businesses goes directly to the bottom line, supports high dividend payouts, share buybacks, or expanding business operations. As long as there are customers who continue to need these basic services, these companies will continue to make lots of money for a very long time.

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