What are the major characteristics of a good business? Why is Toyota an excellent example of a good business?
A decisive competitive advantage, well-designed incentive systems for employees, and a reputable brand backed by product quality are all key characteristics of a good business. Toyota is an excellent example of a good business because its efficient manufacturing processes give it a competitive advantage in the market, its well-designed incentive systems reward employees that contribute to improvements in the company’s processes, and it has established and preserved a brand reputation for reliability and quality.
Read on to understand more about the characteristics of a good business.
What Makes Companies Successful?
According to Munger, outlier business success often results from the combination of some of these factors:
- Extreme focus on maximizing or minimizing one or two variables. For example, Costco focuses on driving volume and lowering prices, to the exclusion of many other factors obsessed over by typical retailers.
- Positive feedback loops, so that success begets further success. These often produce nonlinear results as the combination of multiple multiplicative factors.
- Strong, consistent execution over many factors. For example, Toyota executes well on many aspects of manufacturing, marketing, and capital allocation.
- Riding a rising wave that adds tailwinds even to an otherwise strong company. For example, Oracle rode a wave of improving technology and adoption of technology by businesses.
He went further by explaining the three core characteristics of a good business.
Moats and Competitive Advantage
Munger and Buffett consider one of the major characteristics of a good business to be an enduring competitive advantage—what they call a “moat.” Like a moat protecting a castle, the competitive advantage allows a business to resist being made obsolete by competitors or changing markets.
To highlight the frenzy of competition, Munger points out that of the 50 most actively traded stocks in 1911, only one company—General Electric—survived as an independent, meaningful company. The forces of new technology, fierce new competitors, and shifting management are formidable and can drive companies out of business.
Berkshire Hathaway thus counsels its companies to widen their moats every year. This doesn’t necessarily mean earning more profits each year, but rather growing a company’s strategic position to weather the long term.
Under certain conditions, businesses with large moats can increase prices dramatically without cutting volume, and thus increase earnings dramatically. This happened with Disney in the 20th century. For decades Disneyland priced its tickets very affordably. Then the managers realized it was underpriced—it was a unique experience unlike any on Earth; people don’t consume it that frequently, so they’re not as worried about racking up high costs. So Disneyland raised its prices, and attendance maintained steady levels, leading to sudden profits.
(Shortform note: The recognition of competitive advantage as one of the major characteristics of a good business was formalized by Harvard Business School professor Michael Porter. For more details, read our guide to Understanding Michael Porter.)
Good Incentive Systems
Having a well-designed and fair incentives system is another of the key characteristics of a good business. The incentives in business operations make a big difference in how people behave.
People are prone to getting whatever they can out of a situation. With poorly-designed incentives, people will behave in ways that run counter to your intentions. People get used to sloppy conditions quickly, so it’s important to stop them quickly when you recognize the problem.
Munger cites a friend with a manufacturing business that suffered from extensive fraud in workers’ compensation, which raised the cost of premiums to unsustainable levels. He asked the unions to ask the staff to stop, but they resisted—by then, everyone was doing it and benefiting from it, and it was seen as free money. The friend closed down the plant and moved to Utah, where the Mormon population seemed to be much more honest, and the workers’ compensation costs dropped precipitously.
At times, the right incentive scheme can seem unfair. Munger shares a rule in the Navy—if you’re in charge of a ship and you run it aground, your naval career is basically over. It doesn’t matter what the reason was. This isn’t fair because it punishes officers whose ships run aground through no fault of their own, but the benefits outweigh these costs—officers are more careful than they otherwise would be if the rule weren’t this way. Munger feels the same way about compensation for stress in workers’ comp—while there are legitimate stress injuries, the current system invites so much abuse that society would be better off if compensation for stress were removed.
Trademarks and Branding
The value of trademarks and branding to society is that it gives a strong incentive to preserve the reputation of the brand. Trust in a brand can be lost instantaneously after a scandal or a massive product recall. Therefore, brand owners are likely to invest in product quality, which then means consumers can trust that when they buy a brand name, they’re likely to get quality.
Munger tells an example of how the Carnation food company was attempting to buy the trademark of unrelated company Carnation Fish. The owner of the trademark refused to sell, and ultimately the larger Carnation company capitulated and gave a surprising offer—they would donate time from their food inspectors to make sure Carnation Fish had spotless operations. The value of protecting the Carnation name was so important that the company was willing to invest in similarly named companies it didn’t even own.
(Shortform note: Read more about the value of brand names in our guide to Basic Economics by Thomas Sowell.)
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