Warren Buffett rarely considers aspects of a stock of a company that he might be interested in purchasing for Berkshire Hathaway. He is more interested in the aspects of the business of the candidate company.
Here’s in an effort to clearly summarize Warren Buffett’s strategies on evaluating potential candidate companies for investments of Berkshire Hathaway. While there are not a clear-cut and hard criteria of financial ratios and calculations that Berkshire Hathaway uses to identify potential investments, a compendium of Buffett’s time-tested principles of evaluating potential investments, investors can filter and further research companies that are sound investments and steer clear of the losers they must be avoided at all costs.
- A candidate company must not have large capital expenditure, high costs of maintenance, or cash flow need for new investments. In his 1994 letter to Berkshire Hathaway investors, Warren wrote, “If you are right about a business whole value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.”
- A candidate company must be a player in a good and growing economy or industry. In the Chairman’s Letter of 1996, Warren Buffett stated, “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock.”
- A candidate company’s earnings must be on an upward trend with good and consistent profit margins. “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
- A candidate company must have high and consistent returns on invested capital. Warren Buffet has written, “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.” Also, “Buy companies with strong histories of profitability and with a dominant business franchise.”
- A candidate company must not be exposed to competition from existing and new companies with abundant resources. To quote Warren Buffett, “In business, I look for economic castles protected by unbreachable moats.” When Berkshire Hathaway acquired Burlington Northern Santa Fe (BNSF,) the economic moat was that no other company could easily afford to build a large new rail network across the United States.
- A candidate company must have a demonstrated history of retaining earnings for growth. In one of Berkshire Hathaway’s annual report, Warren Buffet wrote, “… more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.”
- A candidate company must have a strong pricing power and must be free to adjust prices for inflation. In a 2011 interview with the Financial Crisis Inquiry Commission, Warren Buffett stated, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
- A candidate company must enjoy a low debt/equity ratio or a high earnings/debt ratio. To quote Warren Buffet, “I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.”
- A candidate company and it’s products must enjoy a consumer monopoly or have a loyalty-commanding brand. Warren Buffet has said, “I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.” Charlie Munger, business partner of Warren Buffett, stated about Harley Davidson, “Any company that gets its customers to tattoo ads on their chests can’t be all bad.”
- A candidate company must have a strong management that has a history of allocating capital to good business opportunities and profit from such investments. On management, Warren Buffett is quoted as saying, “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.” On capital allocation, Warren has stated, “To decide whether to retain the capital, we have to answer the question: do we create more than $1 of value for every dollar we retain? Historically, the answer has been yes and we hope this will continue to be the case in the future, but it’s not certain.”