Warren’s Checklist for Potential Investments: His Ten Points of Light

 

  1. THE RIGHT RATE OF RETURN ON SHAREHOLDERS EQUITY (ROE = Net_income / Book value): A company with durable competitive advantage almost always shows a consistent high rate of return on shareholder’s equity – typically above 12%. Warren is not after a company that occasionally has high returns on shareholders’ equity. Consistency equates to durability.

Compare the annual rates of return on equity of the following companies, using summary figures provided by Value Line.

Year

Coca Cola

Gap Inc

Wal-Mart Stores

1993

47.7

22.9

21.7

1994

48.8

23.3

21.1

1995

55.4

21.6

18.6

1996

56.7

27.4

17.8

1997

56.5

33.7

19.1

1998

42

52.4

21

1999

34

50.5

22.1

2000

39.4

30

20.1

2001

35

4.3

19.1

2002

35

13.1

20.4

 

 

  1. THE SAFETY NET: THE RIGHT RATE OF RETURN ON TOTAL CAPITAL (ROA = Net_income / Total Assets): Companies with durable competitive advantage will consistently earn both high rate of return on equity and high rate on total capital. Warren is looking for a consistent return on total capital of 12% or better (ideally 20%). For investment banks, and financial companies a return on assets of 1% and consistent ROE of 12% is considered good. Anything over 1.5% on ROA is excellent FOR Financial institutions.

Coca Cola

39.12

American Express

13.68

Gillette

25.93

 

 

  1. THE RIGHT HISTORICAL EARNINGS (EPS = Net Earnings /Outstanding Shares): Historical per share earnings that are both strong and show upward trend indicate a durable competitive advantage. Historical EPS that are widely erratic show a price competitive business.

 

    1. Warren believes that a wonderful investment opportunity exists when a company suffers a onetime solvable problem to which the stock market has overreacted.

 

  1. WHEN DEBT MAKES BUFFET NERVOUS: A good indication that a company has a durable competitive advantage is that it will be relatively free of long-term debt.
    1. Too much long-term debt obstructs in the company’s ability to survive a business recession or calamity.
    2. Companies with a durable competitive advantage have strong enough earnings that they can easily pay off long-term debt within just a few years. This would usually be fewer than five times current net earnings, EXCEPT for Financial institutions.
    3. Long-Term Debt Used To Acquire Another Business: Adding debt to acquire another company may or may not be a good idea. The rule is

                                                               i.      When two companies with durable competitive advantage join together, it will more than likely be a fantastic marriage. The business will spin off lots of excess cash. To pay off loan.

                                                             ii.      When a durable-competitive advantage business marries a price-competitive business, the results are usually mediocre.

 

  1. THE RIGHT KIND OF COMPETITIVE PRODUCT OR SERVICE: The question to ask about the business is, does it sell a brand-name product or a key service that people or businesses are dependent on?
    1. What we are looking for is a brand-name product that has been on the market for years and hasn’t changed at all.
    2. The easiest to identify are things that we buy and use up immediately, such as fast food (KFC, McDonalds, Pizza Hut, etc.)
    3. Then there are things that are consumed over time but wear out within a year or two. (levis jeans, Nike shoes, Geico and AllState insurance).
    4. You want to invest in company that sells something people use everyday, but wears out quickly.
    5. Companies providing services that have durable competitive advantages are much harder to identify. Look for advertising, television Network, Newspapers (Wall Street), Banks (DIB, Meezan)

 

  1. ORGANIZED LABOUR CAN HURT YOUR INVESTMENT: Financial weakness of price-competitive business has given organized labor enormous power to demand a higher cut of the company’s profit. This is especially true whenever you find heavy investment in capital equipment, accompanied by high fixed costs. Examples of these are Airplane pilot strike that cripples the airline heavily. Seldom will you find a durable competitive business with an organized labor force.

 

  1. FIGURING OUT WHETHER THE PRODUCT OR SERVICE CAN BE PRICED TO KEEP ABREAST OF INFLATION: A business with a durable competitive advantage is free to increase the prices of its products right along with inflation, without experiencing a decline in demand. E.g. Nike, Coca-Cola, AllState, Hershey Chocolate, etc.

 

  1. PRECEIVING THE RIGHT OPERATIONAL COSTS: Companies with a durable competitive advantage usually don’t have to spend a high percentage of their retained earnings to maintain their operations. The company should be able to use the retained earnings either to expand its operations, invest in new businesses, and/or repurchase its shares. All three should have a positive effect on per share earnings.

 

  1. CAN THE COMPANY REPURCHASE SHARES TO THE INVESTORS’ ADVANTAGE?: A durable competitive company will have a long history of buying back its shares. This helps the company to increase the future per share earnings of the owner’s who didn’t sell. With share re-purchase Warren has figured out how to acquire a larger ownership interest in a company without having to invest any more money in the company.

 

  1. DOES THE VALUE ADDED BY RETAINED EARNINGS INCREASE THE MARKET VALUE OF THE COMPANY?:

·        Using the retained earnings profitably is not enough for Warren Buffett. The retained earnings must increase earnings substantially. After all, just leaving the earnings in a savings account will increase earnings without any effort.

·        Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

  • ‘You should wish your earnings to be re-invested [by the company] if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment.’