Warren Buffett has long held the belief that people should only buy stocks in companies that exhibit solid fundamentals, strong earnings power, and the potential for continued growth. Although these seem like simple concepts, detecting them is not always easy. Fortunately, Buffet has developed a list of tenets that help him employ his investment philosophy to maximum effect.
Buffett’s tenets fall into the following four categories
1 Business tenets
2. Management tenets
3. Financial tenets
4. Market tenets
Business Tenets
Is the business simple and understandable?
It is important to fully understand the business, its subdivisions, and how the cash is generated. A simple and easy-to-understand business enables an investor to dive deeper into the business process, how it generates sales, incurs expenses, and the problems it is facing. For such businesses, it is easier to proceed with the investigation and predict the future prospects.
Does the business have a consistent operating history?
The company should have the capability to stand the test of time and face different economic cycles and competitive forces. One should ensure that the company is in business long enough to demonstrate an ability, over time, to earn significant profits.
Does the business have favorable long-term prospects?
Does the business have Favorable Long-Term prospects?
The best business to own, the one with the best long-term prospects, is what Warren Buffett terms a franchise, a business that sells a product or service that is needed or desired, that has no close substitute, and whose profits are not regulated.
A franchise typically poses a great amount of economic goodwill that allows a company to better withstand the effects of inflation.
The worst business to own is a commodity business. A commodity business sells products or services that are indistinguishable from competitors. These businesses have little or no goodwill. The only distinction in a commodity business is price. The difficulty of owning a commodity business is that sometimes competitors, using price as a weapon, will sell their products below the cost of business to temporarily attract customers in hopes that they will remain loyal. If you compete against other businesses that occasionally sell their products below cost, the business is doomed.
Management tenets
Is management rational?
How the management reinvests cash earnings determines whether an investor achieves adequate returns on their investment. If a business generates more cash than required to remain operational, then the investors must closely observe the actions of the management. A rational manager will invest excess cash only in projects that produce earnings at rates higher than the cost of capital. If those rates are not available, the rational manager will return the money to shareholders by increasing dividends and buying back stocks.
Is management candid with stakeholders?
The managers should be candid and report the progress of the business in such a way that an investor understands how each operating division is performing. Another desired feature is that management must confess to its failure as openly as it trumpets its success. Management should be dedicated to maximizing the total return on shareholder’s investment.
Does management resist the institutional imperative?
The institutional imperative is the mindless, lemming-like imitation of other managers who justify their actions based on the logic that if other companies are doing it, it must be all right. Managers should be able to think for themselves and avoid herd mentality.
Financial tenets
Focus on return on equity, not earning per share
Most investors judge a company’s annual performance by earnings per share, checking if they set a record or made a big increase over the previous year. However since companies continually add to their capital base by retaining a portion of their previous year’s earnings, growth in earnings is not of much use.
A truer measure of annual performance, because it takes into account the growing capital base, is the return on equity.
Calculate Owner Earnings
Buffett seeks out companies that generate cash in excess of their needs as opposed to companies that consume cash. But when determining the values of a business, it is important to understand that not all earnings are created equal. Companies with a high ratio of fixed assets to profits will require a larger share of retained earnings to remain viable than companies with a lower ratio of fixed assets to profits because some of the earnings must be earmarked to maintain and upgrade those assets. Thus, accounting earnings must be adjusted to reflect the business’s cash-generating ability.
A more accurate picture is provided by owner earnings. To determine owner earnings, add depreciation, depletion, and amortization charges to net income and then subtract the capital expenditures the company needs to maintain its economic position and unit volume.
Look for companies with high-profit margins
High profit margins reflect not only a strong business but also management’s tenacious spirit for controlling costs. Buffett loves managers who are cos conscious and abhors managers who allow costs to escalate.
Indirectly shareholders own the profits of the business. Every dollar that is spent unwisely deprives the owners of the business of a dollar of profit. Over the years, Buffett has observed that companies with high-cost operations typically find ways to sustain or add to their costs, whereas companies with below-average costs ride themselves on finding ways to cut expenses.
For every dollar retained, make sure the company has created at least one dollar of market value
This is an important financial test that reflects the strength of the business, and how well the company has allocated the company’s resources.
Retained earnings of a company is what is left after subtracting the dividends paid to the shareholders from net income. Now add the company’s retained earnings over a 10-year period. Next, determine the difference between the company’s current market value and its market value 10 years ago. If the increase in market value is less than the sum of retained earnings, the company is going backward. On the contrary, the company progresses if the market value increases more than the total dollars retained.
Market Tenets
What is the value of the business?
The value of a business is the estimated cash flows expected to occur over the life of the business, discounted at an appropriate interest rate. The cash flow of a business is the company owner’s earnings. By measuring owner earnings over a long period, you will understand whether they are consistently growing at some average rate or merely bobbling around some constant value.
Can the business be purchased at a significant discount to its value?
After determining the value of the business, the next step is to look at the market price. Buffett’s rule is to purchase the business only when its price is at a significant discount to its value. Only at this final step does Buffett look at the stock market price.
The problem arises when the analysts wrongly estimate a company’s cash flow. Buffett deals with this problem in two ways.
First, he increases his chances of correctly predicting future cash flows by sticking with businesses that are simple and stable in character.
Second, he insists that with each company he purchases there must be a margin of safety between the company’s purchase price and its determined value. This margin of safety helps create a cushion that protects an investor from companies whose future cash flows do not trend as expected.