Buffett Checklist

9 May 2017

 

 

 

Never Forget: Focus on decisions, not outcomes. Look for disconfirming evidence.

 

Consumer monopoly or commodity?

 

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 high return on equity in the past.

 

Understand how business works

 

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.

 

Is the company conservatively financed?

 

Seeks out companies with conservative financing, which equates to a simple, safe balance sheet. Such companies tend to have strong cash flows, with little need for long-term debt. Look for low debt to equity or low debt-burden ratios. Also seek companies that have history of consistently generating positive free cash flows.

 

Are earnings strong and do they show an upward trend?

 

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% (alongwith 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.

 

Has the company been buying back its shares?

 

Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favours 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.

 

Have retained earnings been invested well?

 

Seek companies where earnings have risen as retained earnings (earnings after paying dividends) have been employed profitably. A great way to screen for such companies is by looking at those that have had consistent earnings and strong return on equity in the past.

 

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. Average return on equity for Indian companies over the last 10 years is approximately 16%. Thus, seek companies that earn atleast this much (16%) or more than this. Again, consistency is the key here.

 

Is the company free to adjust prices to inflation?

 

That's what is called "pricing power". Companies with moat (as seen from other screening metrics as suggested above (like high ROE, high grow margins, low debt etc.) are able to adjust prices to inflation without the risk of losing significant volume sales.

 

Does the company need to constantly reinvest in capital?

 

Companies that consistently need capital to grow their sales and profits are like 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.

 

Conclusion

 

Sensible investing is always about using “folly and discipline” - the discipline to identify excellent businesses, and wait for the folly of the market to drive down the value of these businesses to attractive levels. You will have little trouble understanding this philosophy. However, its successful implementation is dependent upon your dedication to learn and follow the principles, and apply them to pick stocks successfully.

 

Source - Buffettology by Mary Buffett & David Clark

 

 

 

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