Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.
Like most successful stockpickers, Warren Buffett thinks that the efficient market theory is absolute rubbish. Buffett has backed up his beliefs with a successful track record through Berkshire Hathaway, his publicly traded holding company.
Defining an Attractive Company
- Commodity-based firms—selling products where price is the single most important factor determining purchase. They are characterized by high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is vital for the long-term success of these types of firms.
- Consumer monopolies—selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.
- Low profit margins (net income divided by sales);
- Low return on equity (earnings per share divided by book value per share);
- Absence of any brand-name loyalty for its products;
- The presence of multiple producers;
- The existence of substantial excess capacity;
- Profits tend to be erratic; and
- Profitability depends upon management’s ability to optimize the use of tangible assets.
- Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. Apple Inc. is a good example of a firm with a strong brand name in demand by customers. As a result, consumers are willing to pay a premium price for Apple products. Other examples include leading newspapers, drug companies with patents, and popular brand-name restaurants such as McDonald’s.
- “Communications” firms that provide a repetitive service, which manufacturers must use to persuade the public to buy their products. All businesses must advertise their items, and many of the available media face little competition. These used to include worldwide advertising agencies, magazine publishers, newspapers, and telecommunications networks. Today, “new media” outlets such as Google and Yahoo! provide on-line advertising that threatens the traditional business models of print media.
- Businesses that provide repetitive consumer services that people and businesses are in constant need of. Examples include tax preparers, insurance companies, and investment firms.
The Buffettology Screen
Consumer monopoly or commodity?
Buffett seeks out consumer monopolies selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. Investors can seek these companies by identifying the manufacturers of products that seem indispensable. Consumer monopolies typically have high profit margins because of their unique niche; however, simple screens for high margins may simply highlight firms within industries with traditionally high margins. For our screen, we look for companies with operating margins and net profit margins above their industry norms. Additional screens for strong earnings and high return on equity will also help to identify consumer monopolies. Follow-up examinations should include a detailed study of the firm’s position in the industry and how it might change over time.
Do you understand how the business works?
Buffett only invests in industries that he can grasp. While you cannot screen for this factor, you should only further analyze the companies passing all screening criteria that operate in areas you understand.
Is the company conservatively financed?
Buffett seeks out companies with conservative financing. Consumer monopolies tend to have strong cash flows, with little need for long-term debt. We screen for companies with total liabilities relative to total assets that are below the median for their respective industry. Alternative screens might look for low debt to capitalization or low debt to equity.
Are earnings strong and do they show an upward trend?
Buffett looks for companies with strong, consistent, and expanding earnings. We screen for companies with seven-year earnings per share growth greater than 75% of all firms. To help indicate that earnings growth is still strong, we also require that the three-year earnings growth rate be higher than the seven-year growth rate. Buffett seeks out firms with consistent earnings. Follow-up examinations should include careful examination of the year-by-year earnings per share figures. As a simple screen to exclude companies with more volatile earnings, we screen for companies with positive earnings for each of the last seven years and latest 12 months.
Does the company stick with what it knows?
A company should invest capital only in those businesses within its area of expertise. This is a difficult factor to screen for on a quantitative level. Before investing in a company, look at the company’s past pattern of acquisitions and new directions. They should fit within the primary range of operation for the firm.
Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favors shareholder-enhancing maneuvers such as share buybacks. While we do not screen for this factor, a follow-up examination of a company would reveal if it has a share buyback plan in place.
Have retained earnings been invested well?
Earnings should rise as the level of retained earnings increase from profitable operations. Other screens for strong and consistent earnings and strong return on equity help to the capture this factor.
Is the company’s return on equity above average?
Buffett considers it a positive sign when a company is able to earn above-average returns on equity. Mary Buffett indicates that the average return on equity for the last 30 years is approximately 12%. We created a custom field that calculated the average return on equity over the last seven years. We then filter for companies with average return on equity above 12%.
Is the company free to adjust prices to inflation?
True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. This factor is best applied through a qualitative examination of the companies and industries passing all the screens.
Does the company need to constantly reinvest in capital?
Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. This factor is best applied through a qualitative examination of the company and its industry. However, a screen for high relative levels of free cash flow may also help to capture this factor.