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Warren Buffett Checklist to Invest in a Great Business: KO

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Oct 25, 2011
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But what has made Buffett so fabulously wealthy? His ability to identify companies he considered more significant than their market value and investing in them for a long term.

That is how he has done it. Now, I should ask myself how I can do it.

Here are Warren Buffett's 9 rules to invest in a great business:

1. Does the business have an identifiable consumer monopoly?

A consumer monopoly is a business that has brand loyalty: a product or service people or companies cannot live without, like toothpastes, biscuits, soft drinks, etc. The best way to identify them is by making a list of the brand-name products and go to the establishment and compare. You will recognize every single product listed — the same you have seen in the ads.

In regard to services, that is much more complex. Where should you look? Television networks, financial service providers (credit card providers), or advertising agencies.

Buffett loves them, but watch out! A business with a profitable brand-new product or service is not necessarily a synonym of success. A thorough analysis should always be made.

2. Are the earnings of the company strong and showing an upward trend?

Always consider a company whose financials are strong and will possibly increase. Despite the brand-name products a company may have, you must always see if the earnings are too unstable to forecast with certainty.

Everyone knows that the key is to buy at a low price and sell at a high one. In fact, that is how Warren Buffett became what he is now.

3. Is the company conservatively financed?

Consumer monopolies usually have strong cash flows, and do not need a large debt burden.

There is no objection — except if a company incurs debts for good purposes, such as to buy another consumer monopoly. The problem arises when the debt is used in such a way that it produces mediocre results, such as the purchase of a commodity business.

4. Does the business consistently earn a high rate of return on shareholders' equity?

Good return on equity. Warren has been permanently interested in high returns. The average return on equity for the last 40 years in America has been nearly 12%, so always look for anything above average.

In fact, that was what Warren did. For instance, he invested in Coca-Cola (KO, Financial) when its return on equity was nearly 33%, and he bought The General Foods Corporation when it was averaging an annual 16% return on equity.

Keep in mind that it is important to consider those companies with a permanent above-average return on equity. You may not be interested in companies with occasional high returns.

5. Does the business get to retain its earnings?

In general, you may want to invest in businesses that are capable of retaining their earnings.

There are exceptions of course. There are businesses that use their retained earnings for maintenance purposes and there are also those that reinvest their earnings to acquire a new business or expand its operations.

6. How much does the business have to spend on maintaining current operations?

You know it is one thing is to make money; it is another thing is to keep it and even something different to not using it for maintenance purposes.

Thus, it is wise to invest in businesses that rarely spend money replacing their fixed assets and hardly employ additional capital.

You must look at a company that manufactures products that never go obsolete, that are simple to produce or have no competition.

As Mr. Buffett puts it: “Predictable product, predictable profits.”

7. Is the company free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?

When you earn money for the first time, you are tempted to spend it. But don't! Reinvest it, as Warren Buffet suggests, and it will bring you a higher return.

What about those businesses without capital employment perspectives? The best option is to pay dividends or use earnings to repurchase shares. The buyback of shares cause per share earnings increases for those who don’t sell and thus make the stock's market price to rise.

Let me tell you, though, that investing in cash cows is Warren's best option. They are businesses that generate a significant amount of free cash flow and do not use much money in research, development or maintenance.

Analyzing management's ability to use retained earnings is paramount for long-term investment. Investing in a company with no opportunities or without managerial skills means failure.

8. Is the company free to adjust prices to inflation?

Inflation and price increase go hand in hand. In commodity-type businesses the cost of producing increases with inflation, and prices have to be reduced as there is a decline in demand and more competition.

On the other hand, consumer monopolies can adjust prices to inflation without suffering a drop in demand. There is little competition.

9. Will the value added by retained earnings increase the market value of the company?

The market has two essential properties: a long-term investment feature, according to which the stock's market price will show its inherent value in time and capital can move on if it is correctly allocated and a short-term feature, comparable to a casino, where there is speculation on price fluctuations.

You should always be on the safe side and look for an increase in the economic value of the company. Don’t depend on speculations.

This is the Warren Buffett way. His nine tenets for investing. No wonder he is called “The Oracle of Omaha.”

You can start using these rules from Warren to eliminate and reduce your own mistakes and develop an investment strategy.
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