Warren Buffett's Investment Checklist
by Ian Bullock
How would your firm look to the premier investor? What does great investment
potential look like to Mr. Buffett?(ed.)
A checklist for the stock selector; the Warren Buffett criteria:
Is the business simple and understandable?
"An investor needs to do very few things right as long as he or she avoids
big mistakes." Above-average returns are often produced by doing ordinary things
Does the business have a consistent operating history?
Buffett's experience has been that the best returns are achieved by companies
that have been producing the same product or service for several years.
Does the business have favourable long-term prospects?
Buffett sees the economic world as being divided into franchises and commodity
businesses. He defines a franchise as a company providing a product or service
that is (1) needed or desired, (2) has no close substitute, and (3) is not
regulated. Look for the franchise business.
Is the management rational with its capital?
A company that provides average or below-average investment returns but
generates cash in excess of its needs has three options: (1) It can ignore
the problem and continue to reinvest at below average rates, (2) it can buy
growth, or (3) it can return the money to shareholders. It is here that management
will behave rationally or irrationally. In Buffett's mind, the only reasonable
and responsible course is to return that money to shareholders by raising
the dividend, or buying back shares.
Is management candid with the shareholders?
Buffett says, "What needs to be reported is data - whether GAAP, non-GAAP,
or extra-GAAP - that helps the financially literate readers answer three key
questions: (1) Approximately how much is this company worth? (2) What is the
likelihood that it can meet its future obligations? and (3) How good a job
are its managers doing, given the hand they have been dealt?" "The CEO who
misleads others in public may eventually mislead himself in private."
Does management resist the institutional imperative?
According to Buffett, the institutional imperative exists when "(1) an institution
resists any change in its current direction; (2) just as work expands to fill
available time, corporate projects or acquisitions will materialize to soak
up available funds; (3) any business craving of the leader, however foolish,
will quickly be supported by detailed rate-of-return and strategic studies
prepared by his troops; and (4) the behaviour of peer companies, whether they
are expanding, acquiring, setting executive compensation or whatever, will
be mindlessly imitated."
Is the focus on Return On Equity?
"The primary test of managerial economic performance is the achievement of
a high earnings rate on equity capital employed (without undue leverage, accounting
gimmickry, etc.) and not the consistent gains in earnings per share."
What is the rate of "owner earnings"?
Buffett prefers to modify the cash flow ratio to what he calls "owner earnings"
- a company's net income plus depreciation, depletion and amortization, less
the amount of capital expenditures and any additional working capital that
might be needed. Owner earnings are not precise and calculating future capital
expenditures requires rough estimates.
Is there a high profit margin?
In Buffett's experience, managers of high-cost operations continually add to
overhead, whereas managers of low-cost operations are always finding ways to
cut expenses. Berkshire Hathaway is a low-cost operation with after-tax overhead
corporate expense of less than 1 percent of operating earnings, compared to
other companies with similar earnings but 10 percent corporate expenses.
Has the company created at least one dollar of market value, for every
Buffett explains, "Within this gigantic (stock market) auction arena, it is
our job to select a business with economic characteristics allowing each dollar
of retained earnings to be translated into at least a dollar of market value."
What is the value of the business?
Price is established by the stock market. Buffett tells us the value of a business
is determined by the net cash flows expected to occur over the life of the
business, discounted at an appropriate interest rate, and he uses the rate
of the long-term U.S. government bond.
Can it be purchased at a significant discount to its value?
Having put a value on the business, Buffett then builds in a margin of safety
and buys at prices far below their indicated value.
Reference to Robert Hagstrom's book The Warren Buffett Way, John Wiley &
Sons Inc., New York, 1994.
Ian Bullock is an
author, reviewer, eagle eye co-editor of The CEO Refresher, investor &
shareholder champion, former CFO
and consultant, residing in Toronto, Canada. Contact Ian by e-mail: firstname.lastname@example.org .
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