Berkshire Hathaway's (BRK.A, Financial)(BRK.B, Financial) Warren Buffet famously said, "Rule number one of investing is to never lose money. Rule number two is to never forget rule number one." But how does one actually go about picking good stocks that have a low probability of declining in value? After all, losses are very difficult to recoup. If your portfolio declines by 50%, you will need an increase of 100% to get back to scratch.
So how does one go about never forgetting rule number one? Here are few financial ratios and metrics that I think investors should keep in mind if they want to invest like Buffett.
Look for efficient capital allocators with low debt
One very important metric to look at is a business's return on capital employed (ROCE). For a brief introduction on what ROCE is, check out this primer. As a quick recap, ROCE is earnings before taxes and interest (Ebit) divided by the sum of long term liabilities and shareholder equity. It is a measure of how efficiently a business uses its available resources to generate profit.
But it's not enough to just look for businesses with a high ROCE. You need to look beyond the surface numbers and figure out what is driving those returns. Ideally, you want a business that has high returns on capital while also having low debt. It's one thing to increase your returns using leverage - it's another to do it with no debt. The best businesses are those that use shareholder equity to create more money, not ones which drive up returns artificially using some sort of financial engineering.
Income and cash flow must be in sync
The funny thing about income statements is that they can sometimes tell a different story to the cash flow statement. This is to some extent unavoidable - if a company books a sale at the end of a quarter, it may not receive payment on that transaction until the beginning of the next quarter, and that is a fine and normal situation. For reasons of convenience, most large companies use the accrual method of accounting, which allows them to recognise revenue before it has actually been acquired.
However, large divergences between cash and income should immediately set off alarm bells, particularly because the financial news typically cares way more about earnings than cash flows. Buffett's best investments have always come from businesses that have stable and predictable cash flows, such as Coca-Cola (KO, Financial), Gillette and American Express (AXP, Financial). These are all relatively simple, easy to understand companies where you can clearly see that the cash coming in and out is in line with the income statement. If you do, you will find it easy to follow Buffett's top two investing rules.
Disclosure: The author owns no stocks mentioned.
Read more here:
- 3 Pieces of Investment Advice From Peter Lynch
- Howard Marks: 40 Years Ago, Nobody Knew Anything
- Howard Marks: Understanding Credit Cycles
Not a Premium Member of GuruFocus Sign up for a free 7-day trial here.
