Buffet’s Checklist for Great Investments
Warren Buffet is one of the most popular investors in the world. He is also known as the “Oracle of Omaha”. He is known for his simplicity and his excellent investment acumen.
Just to put some more context on how great an investor he is – If anyone would have invested $10,000 at the end of 1964 in Berkshire Hathaway, it would be worth $274 Mn at the end of 2019. It just compounded at a rate of 20% CAGR.
If you want to make money like him- here’s the checklist you should read, remember, and practice.
1) Is the company conservatively financed:
Look out for companies that are conservative in their financing. Companies that have a strong balance sheet with low debt and a history of generating free cashflows consistently over long periods.
2) Spotting monopolies:
Seek out companies that have no or less competition, either due to a patent or brand name or similar intangible that makes the product unique. Such companies will typically have high gross and operating profit margins because of their unique niche. However, don't just go on margins as high margins may simply highlight companies within industries with traditionally high margins. Thus, look for companies with gross, operating, and net profit margins above industry norms. Also, look for strong growth in earnings and a high return on equity in the past.
3) Invest in businesses that you understand:
Try to invest in industries where you possess some specialized knowledge (where you work) or can more effectively judge a company, its industry, and its competitive environment (simple products you consume). While it is difficult to construct a quantitative filter, you should be able to identify areas of interest. You should "only" consider analyzing those companies that operate in areas that you can clearly grasp - your circle of competence. Of course, you can increase the size of the circle, but only over time by learning about new industries. More important than the size of the circle is to know its boundaries.
4) Earnings growth? :
Rising earnings serve as a good catalyst for stock prices. So seek companies with strong, consistent, and expanding earnings (profits). Seek companies with 5/10 year earnings per share growth greater than 25% (along with safe balance sheets). To help indicate that earnings growth is still strong, look for companies where the last 3-years earnings growth rate is higher than the last 10-years growth rate. More important than the rate of growth is the consistency in such growth. So exclude companies with volatile earnings growth in the past, even if the "average" growth has been high.
5) Does the company operates within a circle of competence? :
As you should stick to your circle of competence, a company should invest its capital only in those businesses within its circle of competence. 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 operations for the firm. Be cautious of companies that have been very aggressive in acquisitions in the past.
6) Share Buybacks by the company:
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.
7) Does the company need constant capital to grow? :
Companies that consistently need capital to grow their sales and profits are like a bank savings account, and thus bad for an investor's long-term portfolio. Seek companies that don't need high capital investments consistently. Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. Here, more than just an absolute assessment, a comparison against competitors will help a lot. Seek companies that consistently generate positive and rising free cash flows.
8) Is the company’s return on equity above average? : Consider it a positive sign when a company is able to earn above-average (better than competitors) returns on equity without employing much debt. The average return on equity for Indian companies over the last 10 years is approximately 16%. Thus, seek companies that earn at least this much (16%) or more than this. Again, consistency is the key here.
9) Is the company free to adjust prices to inflation? :
That's what is called "pricing power". Companies with a moat (as seen from other screening metrics as suggested above (like high ROE, high growth margins, low debt, etc.) are able to adjust prices to inflation without the risk of losing significant volume sales.
10) Is the company’s return on equity above average? :
Consider it a positive sign when a company is able to earn above-average (better than competitors) returns on equity without employing much debt. The average return on equity for Indian companies over the last 10 years is approximately 16%. Thus, seek companies that earn at least this much (16%) or more than this. Again, consistency is the key here.
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PS: This post is inspired by Safal Nivesak and Buffettology by Mary Buffett & David Clark