"Mr. Buffett, what types of companies will you purchase in the future?"

Buffett is often asked what types of companies he will purchase in the future.

First, he says, he will avoid commodity businesses and managers in which he has little confidence.

What he will purchase is the type of company that he understands, one that possesses good economics and is run by trustworthy managers. 

"A good business is not always a good purchase,"  Buffett says, "although it is a good place to look for one."

For Buffett, the activities of a common-stock holder and a businessperson are intimately connected.  Both should look at ownership of a business in the same way.  "I am a better investor because I am a businessman," confesses Buffett, "and a better businessman because I am an investor."

Evaluating a Company - 10 Simple Rules

Having identified the company of interest and assembled the financial information, do the following analysis.

1.  Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?

2.  Do you understand how the company works?  Do you have intimate knowledge of, and experience with using the product or services of the company?

3.  Is the company conservatively financed?

4.  Are the earnings of the company strong and do they show an upward trend?

5.  Does the company allocate capital only to those businesses within its realm of expertise?

6.  Does the company buy back its own shares?  This is a sign that management utilizes capital to increase shareholder value when it is possible.

7.  Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.

8.  Is the company's return on equity (ROE) above average?

9.  Is the company free to adjust prices to inflation?  The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.

10.  Do operations require large capital expenditures to constantly update the company's plant and equipment?   The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.


Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options.  Let the market price determine the buy decision.  

Excellent businesses that can consistently earn high ROE are often bargain buys even at seemingly very high P/E ratios.

The secret that Warren has figured out is that excellent businesses that benefit from a consumer monopoly, that can consistently earn high rates of return on shareholders’ equity, are often bargain buys even at what seem to be very high price-to-earnings ratios.

Investor's Checklist: Consumer Goods

Find companies that enjoy the cost advantages of manufacturing on a larger scale than most other competitors.  One related issue is whether the firm holds dominant market share in its categories.

Look for the firms that consistently launch successful new products - all the better if the firm is first to market with these innovations.

Check to see if the company is supporting its brand with consistent advertising.  If the firm constantly promotes its products with sale prices, it's depleting brand equity and just milking the brand for shorter-term gain.

Examine how well the firm is handling operating costs.  Occasional restructuring can help squeeze out efficiency gains and lower costs, but if the firm is regularly incurring restructuring costs and relying solely on this cost-cutting tactic to boost its business, tread carefully.

Because these mature firms generate so much free cash flow, it's important to make sure management is using it wisely.  How much of the cash is turned over to shareholders in the form of dividends or share repurchase agreements?

Keep in mind that investors may bid up a consumer goods stock during economic downturns, making the shares pricey relative to its fair value.  Look for buying opportunities when shares trade with a 20 percent to 30 percent margin of safety.  

Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



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Investor's Checklist: A Guided Tour of the Market...

Where to Look for a Consumer Monopoly

Warren Buffett has discovered that there are basically four types of consumer monopolies:

1. Businesses that make products that wear out fast or are used up quickly, that have brand name appeal, and that merchants have to carry or use to stay in business.

2. Communications businesses that provide a repetitive service that manufacturers must use to persuade the public to buy their products.

3. Businesses that provide repetitive consumer services that people and business are consistently in need of.

4. Retail stores that have acquired a quasi-monopoly position selling such items as jewelry and furniture.

Determining if the Business Has a Consumer Monopoly

A consumer monopoly is usually evidenced by a brand name product or key service.

Warren Buffett looks for the consumer monopoly to produce earnings that are strong and show an upward trend.

A company that benefits from the high profits that a consumer monopoly produces will usually be conservatively financed. Often it carries no debt at all, which means that it has considerable financial punch to solve problems and to take advantage of new business prospects.

Warren Buffett believes that in order for a company to make shareholders rich over the long run it must earn high rates of return on shareholders' equity.

He also believes that the company must be able to retain its earnings and not have to spend it all on maintaining current operations.

The Healthy Business: The Consumer Monopoly (Where Warren Finds all the Money)

A consumer monopoly is a type of toll bridge business. If you want to buy a certain product you have to purchase it from that one company and no one else.

Warren Buffett's test for a consumer monopoly is to ask himself whether it would be possible to create a competing business even if one didn't care about losing money.

A consumer monopoly sells a product where quality and uniqueness are the most important factors in the consumer's decision to buy.

Consumer monopolies, though excellent businesses, are still subject to the ups and downs of the business cycle and the occasional business calamity.

The Economic Engine Buffett Wants to Own

Warren Buffett has separated the world of business into two different categories:

1. the healthy consumer monopoly type business and
2. the sick commodity type business.

A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly.

A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell.

Warren Buffett believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market.