Beginners and Pro alike consider stock picking as the single most important skill in investing. It is a skill that you must learn, if becoming a better investor is part of your goal.
What’s better way to learn this skill than from Buffett himself, who is arguably the greatest stock picker of all time.
The surprising thing about Buffett’s school of investing is that it is downright simple. It is so simple that even a child can understand. Don’t get me wrong. Understanding the principles is one thing, applying them in your decision making is quite another. Most people fail in the second front, not first.
Notwithstanding, it will still make you a better investor if you just grasp these principles fully.
Here are the 5 characteristics of great companies which Buffett loves to invest in :
1. A Consumer Monopoly
A consumer monopoly is a business with little or no competition. They are “best in breed” businesses in their sector. Contrary to their evil twin, commodity-type businesses, consumer monopolies do not compete on price.
These types of companies are often characterized by presence of an economic moat that makes it nearly impossible for its competitor to enter the market.
This economic moat can be in the form of
- A strong brand
- An exclusive deal
- Strong and difficult to replicate distribution network
- Patents or
- Other proprietary assets.
Such companies have freedom to increase prices of their products as they see fit without affecting their business.
Coca Cola is one such example. There is not a person on earth who isn’t aware of Coca Cola brand. That combined with the level of distribution it has achieved over 127 years has made is sort of invincible in soft drink market.
Think about it for a moment. Virtually no company on planet, both new and old, has a realistic chance of defeating Coke in its own game, no matter how less they charge for their sugared water.
This is because Coke is not competing with its competitors on the basis of price or taste of its products. It has capitalized on its strong brand and amazing distribution network-things which are extremely difficult to replicate.
Consumer monopolies however, need not be as large as Coke. They could be present in your neighborhood. A strategically located retail store having an exclusive right to sell certain type of product can also be an example consumer monopoly.
Bottomline : Look for companies which have a strong economic moat around it that sort of makes it invincible.
2. A Strong Earning Track Record.
The age-old question “Why we are here?” can be applied to businesses as well. Although, it may be argued that life has a purpose, businesses unarguably come with a purpose. The purpose of making money. That’s right! Profit is the ultimate reason most if not all businesses exist.
Therefore, it is no surprise that Buffett looks for companies with a strong track record of earnings. Buffett goes as far as 10 years down in the past to look for a track record he desires. What he looks for is growth in earning and consistency in growth.
Consistency is important because it makes the company predictable for valuations. Buffett does not invest in companies he can’t value, which are often companies whose earnings are sporadically spread over the years.
There is nothing arbitrary about selection of the time interval in which the earnings are examined. 10 years is a long enough a period for weaknesses (if any) to bubble up. Companies which can’t maintain consistency in their earning growth are often the ones who will falter in difficult times. They are weak by their nature and can be replaced by stronger counterparts.
Bottomline: Look for a strong growth in earning and consistency in growth for at least 10 years.
3. A Healthy Return On Equity
Equity is nothing but owners’ money put at the time time of starting the business plus any retained earnings.
Return on equity or ROE= Profit/ Equity
According to Buffett, after earnings, ROE is the most important measure of a company’s financial health. The reason for this is two fold :
First, for each subsequent year the retained earnings from the previous year adds to the existing equity (the denominator). In order for ROE to remain constant, Profits must grow by an equal factor. This essentially means a healthy return on equity tells us that company’s profit is growing at a good rate.
Return on equity can broken down into three important factors that represent business’s financial health :
ROE = Profit/Sales *Sales/Asset * Asset/Equity
Profit/Sales = Profitability
Sales/Asset = Asset Productivity
Asset/Equity = Capital Structure
A healthy return on equity for a period of 10 years often means the company has good profitability, its assets are productive and has a sound capital structure.
Bottomline: Look for companies whose ROE is high (higher than 15%) and has remained so in the past 10 years.
4. A Healthy Net And Gross Margin
The key principles in seeking healthy gross and net margin is, once again boils down to earnings. Gross margin is found by dividing gross income (revenue minus cost of goods sold) by total sales. Net margin is found by dividing net income (everything leftover in the income statement) by total sales.
The larger the numbers the better. A business that has been able to deliver high gross and net margin over the years is often a consumer monopoly that beats both the industry average and global industry averages.
Buffett looks for high gross and net margin because it often means the company isn’t trying to squeeze its profits in its effort to grow. Because believe it or not, if your growth depends on squeezing profits, in few years you may grow big but your profit (or bottomline) will remain small. Or worse, it may turn negative. And as such, growth can become your enemy. (If you lose $1 selling one product, you will lose $1 million if you sold a million.)
A high net and gross margins also says the factors of production are more and less in company’s control and not in control of external environment such as government regulations. Buffett doesn’t like to handover fate of his companies in the hands of external factors such as Government and therefore he doesn’t invest in companies which can’t maintain a high net and gross margin over the long term.
Bottomline: Look for companies which were able to maintain high Gross and Net Margins (Higher than industry average) for a period of 10 years.
5. Possessing A Low Level Of Debt
This is very very important. I have already written about how debt can be a poison in your personal life. A company’s life is no different. Debt can potentially destroy biggest of corporations. Lehman Brothers, anyone?
Buffett likes to stay conservative and looks for a debt to profit ratio of less than 3. This means the company should be able to pay most of its debt in 3 years through profit alone.
Bottomline: Always remember, leverage is a double edged sword and stay away from companies which use too much leverage.
By no means, this is a complete list of characteristics all great companies share. But for those who lack time (and energy), it can be handy to check for these vital signs that makes a company great. Think of it as a list to filter bad companies. A company that has all these characteristics may or may not be worth investing in (because ideally you would still want to pay a fair price), but a company which lacks any of the above features is certainly the one you should stay away from (regardless of its price).