If you know anything about Warren Buffett, you know he loves investing in great companies. In fact, he and Charlie Munger (Trades, Portfolio)'s entire investing strategy centers around finding great companies at fair prices. But what does that entail? While I'm positive Buffett can explain that better than me, I'm still going to take a shot at it:
- Management.
- Profitability and moat.
- Balance sheet.
“Time is the friend of the wonderful company, the enemy of the mediocre.”
— Warren Buffett (Trades, Portfolio)
Management
Buffett and Munger are huge on investing in "wonderful" companies, and one of the most important aspects of that is solid management. That being said, how do you verify if management is trustworthy and/or capable? A few ways:
- BVPS growth -Â Can also use EBIT growth as well. Both of these numbers verify if management is capable of increasing shareholder value. Ideally you want to see five to 10-year growth of 15% or more with both numbers.
- Shares outstanding trend - Analyze diluted number of shares trend over the last 5 to 10 years or so. If you see a downward or relatively flat trend, that means management is not issuing more and more shares to finance growth. The business is either growing organically or management is figuring out ways to keep shareholder value from being diluted. Either way is great for you.
- Retained earnings to market value - A test to see if management can create $1 of market value for every $1 of retained earnings. Buffett uses this text extensively, and I wrote an entire article on it if you care to read more about the test.
- Annual reports - The only true way to determine if you can trust management is to simply pick up and read the annual reports. Start five years ago and see if what management says actually happens.
Profitability and moatÂ
Most great companies —Â and investments —Â all have the ability to produce above-average profits. As Buffett says, "We prefer demonstrated consistent earning power." The three main ones are:
- Gross - Should be high, as in over 30-40%.
- Operating - Mimic gross and be consistent with sales growth.
- Net - Above industry average.
As for a moat —Â otherwise known as a competitive advantage —Â there are two excellent metrics I like to analyze to determine if one exists, return on equity (ROE) and return on invested capital (ROIC). Look for a ROE and ROIC of greater than 15% for at least five years, preferably 10.
Why, you ask? In one of Berkshire Hathaway'sletter to shareholders, Buffett mentions he uses two tests to determine economic excellence. The first is the company has to have 10 years of a return on equity greater than 20%, and the second is the company could not have any year worse than 15%. As you can imagine, not many companies fit the bill. According to a Fortune Magazine study, only 25 firms out of 1,000 passed from 1976 to 1986. The most astonishing number is 24, as in 24 out of the 25 companies outperformed the S&P 5oo during that timeframe. And since ROIC is close related, you should pay close attention to these metrics. They can tell you a lot.
Balance sheet
A company can have great earnings, positive cash flow, growing sales and still be in trouble if it is weighted down by too much debt —Â which is why it is crucial to scour the balance sheet and look for problem areas.
Two metrics to identify are debt to equity (Short- + Long-Term Debt / Total Equity) and the current ratio (Current Assets / Current Liabilities). The debt to equity ratio identifies if the company is being financed too heavily with debt. Obviously companies with lower debt/equity ratios are preferable (ideally less than 0.5). The current ratio identifies if the firm can meet short-term obligations with short-term assets. Higher the better (ideally greater than 2).
But don't stop there. Head over to the cash flow statement and check out the company's free cash flow. Not only should this number be positive, but steadily increasing as well.
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