What Makes a Company Great?

What do we mean when we refer to “the best companies to own”?

This week, we published our inaugural list of "Best Companies to Own." In this article, data journalist Margaret Giles describes in detail how we picked these publicly traded companies. The criteria will be no surprise to those who follow Morningstar equity research.

But before you dig in, I wanted to provide some context on just how distinguished this list really is and offer a couple suggestions on how to use it.

Putting the List Into Context: 4 in a Million

This list of 123 enterprises really represents the crème de la crème of global industry. Let’s look at just how thin that layer of cream is.

First, consider that the United States is home to more than 32 million businesses. Most of them are small and privately owned, but they still employ nearly half the U.S. workforce (70-something million of about 160 million workers). These are mostly involved in healthcare, hospitality, and construction, according to the Small Business Administration.

About a fourth of private businesses have any employees other than their owners, who in most cases are running their personal business (think musicians, therapists, electricians, and more). In any given year, about a million U.S. small businesses are formed and another million are discontinued.

Some of these small and private businesses may well be great companies, by which--wearing our investor cap--we mean we might want to own part of them because they provide durable, long-term profits and/or measurable and moderate risk. Most small businesses never seek outside investment, though, or they grow based on loans and investments from close relations of the founder.

Why Invest in Companies at All?

To understand the companies that do seek outside investment, we turn to data from Morningstar subsidiary Pitchbook. There are 268,000 private companies in Pitchbook's database that are backed by outside investors, which means they sought and received infusions of money (also known as capital) to fund ambitious business plans like revolutionizing agriculture, making sustainable food, or launching into space. In exchange for ownership of a percentage of the firm (and thus a share of its profits), these private investors provide money to fund those activities, hire people, build the product, and so on.

Typically, the size of the investment pool for a given business corresponds to the opportunity that the enterprise has before it.

If a business aims to work locally, it may not need significant investment to succeed. But if it is aiming still bigger--and there’s a good amount of money poured into the company during the initial rounds of private investment--a firm will often orchestrate offering its stock to the investing public. This opens the door to a continuous source of investor capital, which it can gain access to by issuing new stock shares. And holders of those shares, for their part, can increase their own financial wherewithal by trading them back and forth based on their estimate of the firm's prospects and attractiveness.

Why do companies choose this path? There are a few reasons, but one worth noting is that large companies can do some things that individuals cannot do as easily or as well.

This phenomenon is referred to as economies of scale, meaning when an activity is performed a lot (in large quantities or repetitively over time), it gets easier or cheaper.

Consider a mom-and-pop establishment that spends 2% of its revenue on (presumably local) ads. The business may reach only a few thousand people and may not increase its traffic or bottom line much.

But when a national chain retailer such as Domino's Pizza DPZ, Yum China Holdings YUMC, McDonald's MCD, or Starbucks SBUX--all present on the list--spends a few percent of revenue (which amounts to billions of dollars annually) on marketing or promotions? That firm can take advantage of national networks of radio, TV, and cable stations to reach most of the households in its market and run a much higher chance of boosting sales to its outlets.

Public Investor Interest

Every firm on the list has succeeded at employing economies of scale, earns extremely high revenue, and consequently has attracted the interest and confidence of investors.

Only four companies on our list have less than $1 billion in annual revenue (and those have at least $600 million), and they average over $30 billion in yearly sales. Together, the stock market values of these firms add up to just above $18 trillion. That's about 40% of the total U.S. market, which is made up of more than 4,000 more companies.

Though the constituents of our list average $100 billion in market capitalization, the range is still quite wide: For instance, Microsoft's MSFT $2.5 trillion is about 400 times the market cap of LandStar System's LSTR $6 billion. In sum, this means investors already appreciate the attractive qualities of these businesses.

Moreover, most of them have been at it for a while. PepsiCo PEP, for instance, originally listed its shares in 1919--more than 100 years ago.

Apex Competitors These statistics present a snapshot of an ever-churning population of enterprises. They follow a broad pattern known as the "business life cycle": birth, growth, infusion of investment, potentially more growth, achieving relevant scale, maturity, and sometimes death or acquisition.

That said, what we see in the Best Companies to Own list are firms that have endured these many milestones successfully. And we see that they continue to steward their businesses and reinvest capital in attractive projects (or return it to shareholders as dividends, buybacks, and the like).

They’ve already made it to the big game by being among the relatively few U.S. companies to be publicly listed. But these 123 companies further distinguish themselves from the crowd by meeting additional criteria: They all have superior and durable competitive advantages, business models that allow forecasting of their results with a good amount of certainty, and a competitive position that’s likely to strengthen over time.

The point is that to appear on this list of Best Companies to Own means a lot. If you want to learn more about some common attributes of companies that succeed over time, I recommend the book Good to Great by Jim Collins.

How to Use This List

Yes, these firms represent the cream of the crop of global industry--but that doesn't mean you should fire off 123 buy orders in your brokerage app.

If you are a stock-picker, consider these names as candidates for further viewing in your watchlist of investment research. Pay attention to the valuations, maybe flag some you are more interested in, and develop a plan to add them to your portfolio at an opportune time. Morningstar's index of the most cheaply valued wide-moat companies listed in the U.S. is rebalanced every quarter, and you can track it here with a subscription or here for free.

If you mostly invest in funds, check out the Instant X-Ray to see whether you already own shares of these names within one or more of your funds. Take pride in the fact you own some of these most distinguished companies that still offer opportunity for fruitful investment in their franchises.

And as above, put a few on your reading list to learn more about. Some may comprise a meaningful chunk of your portfolio, by way of their large market cap or potentially a selection by one of the managers you have hired to run your fund portfolio.

And finally, I invite you delve deeper into our list, where we will break out the best sustainable companies, financials firms, tech stocks, and businesses based outside the U.S.

Nicolas Owens owns YUMC.