Small Cap Foolish 8 Two Good Small-Cap Questions

It's smart to invest in good small companies and pass on the bad, but how do you tell the difference? In this classic column from February 13, 2001, Brian Graney offers some advice from two great investors in the form of two questions to ask yourself: Would you like competing against this company, and would you jump at the chance to buy it and run it yourself?

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By Brian Graney (TMF Panic)
July 10, 2001

What differentiates a "good" company from a "bad" company?

There are many ways to answer this question, and most investors tend to rely on their own personal yardsticks. A numbers-minded investor might answer that a "good" company will have higher profit margins or faster inventory turns or lower maintenance capital expenditure requirements than a "bad" company. On the other hand, a competition-minded investor might pin the "good" company label based on higher market share or a stronger brand name or a larger customer base. These are all attributes that "good" companies might have and "bad" companies might lack.

Based on the many ways of looking at companies, different investors might get different answers as to what a "good" company looks like. However, there are a few ways to cut through the individual viewpoints and reach a more general and holistic definition of a "good" company.

Some insights can be gleaned from the shortcuts that great investors use to approach the question. Two shortcuts in particular stand out, not only because they incorporate many of the elements of business quality into a neat and tidy package, but also because they are simple enough for any level investor to incorporate and use effectively when looking at practically any company.

The first shortcut for finding "good" businesses comes from Warren Buffett. No great surprise there. Buffett is an all-time great investor, and he happily shares boatloads of his timeless investing common sense to anyone who cares to listen in his annual letters to shareholders of Berkshire Hathaway (NYSE: BRK.A). In his 1983 letter, Buffett suggested this piece of advice for identifying "good" companies:

"One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it."

As with many of Buffett's comments on investing, this simple statement gets to the root of what can be an incredibly complex issue. If you shudder at the idea of trying to compete with the company you are researching, Buffett's conclusion would appear to be that it's a pretty valuable enterprise. (My thanks go to Tiddman, a frequent contributor to the Berkshire Hathaway discussion board, for unearthing this quote.)

Of course, Buffett has an advantage over most individual investors -- he has actually run various businesses during his lifetime and knows exactly what is involved. Still, if you are adpoting a business-minded approach to investing in stocks, there's no excuse for not looking at companies in the same way an entrepreneur would and asking a question like this.

Ralph Wanger, a small-cap fund manager with an impressive investing track record in his own right, offers a slight twist to Buffett's question. Instead of imagining what it would be like to compete against a particular company, Wanger suggests imagining what it would it would be like to run it outright in his book, A Zebra in Lion Country:

"I pretend that someone has called me and told me that First National Bank has just authorized a line of credit sufficient for me to buy all of the stock in this company at current market value. Am I willing to leave my mutual funds and take over and run the company?  

"Most of the time, the answer is, 'Hell, no.' But every once in a while I say to myself, 'God, I bet I really could do something with this company.' Those are the stocks I buy with the greatest conviction and excitement."

Like Buffett, Wanger is also in a different spot than most investors. He, too, knows a great deal about running a business firsthand, and he's also got a job he doesn't appear that anxious to leave. (He's been managing the Acorn Fund for over 30 years.)

Asking these questions may seem whimsical and hokey to some investors, especially those interested in large, complex companies. After all, who would realistically be able to imagine giving IBM (NYSE: IBM) a run for its money, or inserting themselves in the top spot at Eastman Kodak (NYSE: EK)? But for the small company investor, asking these questions is easier. Could you run the company better, and would you want to? If you decide to buy the company's shares, you are in effect going into partnership with the folks who run the firm, so you might as well think about things from an ownership perspective from the start.

Asking these two questions -- would you like to compete against this company and would you jump at the chance to buy it and run it -- are simple ways to separate the "good" small companies from the "bad" in your own mind. These questions don't replace sound business analysis, such as looking for companies with sustainable competitive advantages, financial strength, attractive growth opportunities, and management teams dedicated to the idea of building shareholder value. In fact, these questions indirectly call for the investor to make the most reasoned and objective investing decisions possible. That's why they've worked so well for Buffett and Wanger in the past.

Brian Graney has never run a company, but he did run track in high school. At the time of publishing, he owned shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.