So what are the markers of great businesses that will compound capital at above average rates? We think there are a number of things.
The first is the business model itself. To this day, MasterCard and VISA have net margins that are in the low 30% whereas average American business earns probably between 5-10%. You can cut MA and VISA’s margin in half and still better than average. The business is so good that it’s hard to reinvest the cash generated. There are certain things that we can understand and we try to stick to them. We spend time to figure out what it is about the business model that causes the above average returns. In other words, what are the moats of the business? If you ask me what the moat of VISA and MasterCard is, I can tell you we don’t know exactly what it is but here is what we think. There is the ubiquity of acceptance worldwide. The banks, which are their customers, give them enormous amount of trust. MA and VISA make some profit on exchange network but the banks make the most money. And we think the most important is that they have a very very and let me stress that, very complex pricing models. MA has more than 3000 pricing models and they have no transparency. Therefore, the cards are generating so much profit for the banks.
However, everybody wants a piece of the high return business, which makes sense. So today there’s the threat of mobile payment. VISA and MA pay a lot of money to buy new tech that involves mobile payment and they spend a lot of time buying back stocks. They face the dilemma of deploying the cash generated.
The second issue we deal with is the management. We spend time trying to see that if they treat all shareholders as partners. One of the questions I ask management is how do you measure the success of the business. And people say price of stocks or stuff like that. It’s rare to find someone to say it’s measured by growing real economic value per unit. It’s rare because they are not trained to think like investors. But that’s the answer I like.
And the third point is reinvestment. We talked about VISA (V) and MasterCard (MA). Their return is so staggering that they can’t find businesses that have those kinds of returns. But reinvestment is the one place where manager can create or destroy more value. So we look at the history of reinvestment and we look at the track record. We want to find businesses whose managers can reinvest the capitals at an above average rate of return. And when we have that, we have what we call the compounding machine. We are interested in compounding our capital and we don’t have a sell price. What we do is to buy exceptional business and hold them until they are no longer exceptional. It’s not complicated.