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Here's the recipe for a 'perfect business' --- and a tasty stock - MarketWatch

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A colleague once suggested to me the idea of the “perfect business.” I was skeptical but listened to the elaboration. A perfect business requires no incremental capital, yields functionally infinite returns and has indefinite duration. One downside of a no-capital business is absence of internal reinvestment opportunities. So the operator of such a business must have skills beyond managerial savvy, specifically capital allocation acumen and management recruiting astuteness.  

Such a perfect business is rare, and a competent executive possessing all of the skills needed to lead it is rarer still. That’s why stock analysts are skeptical, apply valuation discounts, and assume that any outperformance will soon reverse. The need to reinvest profits in new and different businesses creates complexity. The best way to address that is to maintain the businesses as autonomous and decentralized units. But this structure produces another downside — opacity — which again dampens investor assessments.

Yet those involved in creating and working for such perfect businesses are eager to invest their own capital as well — legions of its managers invest heavily in the company. The resulting cohort of independently wealthy managers who are faithful stewards reduces turnover, adds stability, and sustains culture. Such managers are also trustworthy with long-term outlooks, important elements of an autonomous and decentralized firm. The result is a virtuous circle.

Add to that exposure to taxes on their capital at risk, and you get a company run for likewise taxable owners rather than non-taxable institutions. The ultimate challenge for such perfect businesses is — besides the fateful point when they can no longer reinvest profits successfully — is to mitigate the risk of breaking the virtuous circle.

To meet that challenge requires, first, offering owner/operators an attractive investment proposition that meets three criteria: (1) generate above-average returns, (2) be understandable and direct (not via intermediaries), and (3) subject to the operator’s influence. Such people, in turn, will eagerly grow their business and widen its competitive advantage, or moat, and adopt a long-term outlook. A well-developed investment or acquisition apparatus would enable the perfect business to repeatedly accommodate the owner/operators it attracts. 

Second, the perfect business must maintain both decentralization and its organization-wide culture, raising a threshold question about the division of responsibility on these subjects between directors and managers.  In corporate governance generally, directors direct and managers manage. Are structure and culture for the board of directors or managers or both? At the perfect company, the answer is almost certainly that both issues are shared responsibilities.

Decentralization is essential to attracting and retaining business sellers seeking to succeed as owner/operators. Ironically, their senior managers are one obstacle to decentralization, as they often believe in their own administration.  Yet once they are overseeing a large number of businesses, their team cannot comprehend the whole. Segmenting into groups helps, with group presidents, ideally equipped with administrative apparatus.

Culture is likewise deeply embedded in the strategy of the perfect business. True, managers have primary responsibility and the board needs a formal succession plan, but who intervenes upon deviation, including by successor CEOs?  At the perfect company, the board and management are in sync. 

Management expert Tom Peters advocates what I call “intelligent autonomy” — loosely delegate and decentralize around tight parameters that define outstanding performance. A strong organizational culture is required. There is something to be said for adopting an express statement or commandments, with someone gathering consensus and writing them up. Yet ironclad rules stifle adaptability, which is another requirement of the perfect business. Better to keep any written code loose and flexible.   

Concerning risks to the operation, what might disrupt this virtuous circle are “people issues,” not “business issues.” CEO succession, for example, is mitigated by the perfect business’s ability to develop group leaders.  As they are the embodiment of corporate culture, their departure would be a big blow. But the likelihood is low given leaders’ attachment to the culture — the perfect company’s culture would have to change radically to induce serial departures.

The biggest risk is board succession: If the board created an uncongenial managerial environment, defection risk would surface. The company should want strong directors but only those aligned with its culture — a strong contrarian director is a disaster. So the perfect company’s “help wanted” sign for directors reads:  Seeking competent, diligent, long-term director who gets the perfect company’s business, model, and values. Sounds like a perfect job. 

Lawrence A. Cunningham is a professor at George Washington University, founder of the Quality Shareholders Group, and publisher, since 1997, of The Essays of Warren Buffett: Lessons for Corporate America. For updates on his research about quality shareholders, sign up here. 

More: 10 companies that know how to spend money so you have a chance to make some

Plus: Why high-quality, trustworthy companies have beaten the S&P 500 by 30%-50%

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Here's the recipe for a 'perfect business' --- and a tasty stock - MarketWatch
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