How does Warren Buffett (Trades, Portfolio) find suitable businesses to add to his Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) empire? What does he look for when sorting the wheat from the chaff?
Over the years, Buffett has explained his acquisition criteria in his letters to investors. These insights are valuable not only to business owners, but also investors, as they are a look into Buffett’s process.
It is clear from the "Oracle of Omaha’s" writing that he is looking for a particular type of business to acquire, one that is run by exemplary management with a history of generating high returns.
Buffett is looking for leadership teams who manage the business as if it were their own, not managers who are looking to make a quick buck from shareholders. In addition, Buffett tries to avoid companies with massive pension obligations and those that make extensive acquisitions with debt or shares. Here are some quotes from investor letters giving insight into the process.
Buffett on hunting for acquisitions
1981 letter to shareholders:
“The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being Self-defeating.”
1984 letter to shareholders:Ă‚
“Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)”Â
1985 letter to shareholders:Ă‚
“We frequently get approached about acquisitions that don’t come close to meeting our tests: new ventures, turnarounds, auction-like sales, and the ever-popular (among brokers) 'I’m-sure-something-will-work-out-if-you-people-get-to-know-each-other.' None of these attracts us in the least.”Â
Ă‚ 1992 letter to shareholders:
“In making acquisitions, Charlie and I have tended to avoid companies with significant post-retirement liabilities. As a result, Berkshire's present liability and future costs for post-retirement health benefits though we now have 22,000 employees - are inconsequential. I need to admit, though, that we had a near miss: In 1982 I made a huge mistake in committing to buy a company burdened by extraordinary post-retirement health obligations. Luckily, though, the transaction fell through for reasons beyond our control. Reporting on this episode in the 1982 annual report, I said: 'If we were to introduce graphics to this report, illustrating favorable business developments of the past year, two blank pages depicting this blown deal would be the appropriate centerfold.' Even so, I wasn't expecting things to get as bad as they did. Another buyer appeared, the business soon went bankrupt and was shut down, and thousands of workers found those bountiful health-care promises to be largely worthless.”Â
2000 letter to shareholders:Ă‚
“Two economic factors probably contributed to the rush of acquisition activity we experienced last year. First, many managers and owners foresaw near-term slowdowns in their businesses ¾ and, in fact, we purchased several companies whose earnings will almost certainly decline this year from peaks they reached in 1999 or 2000. The declines make no difference to us, given that we expect all of our businesses to now and then have ups and downs. (Only in the sales presentations of investment banks do earnings move forever upward.) We don’t care about the bumps; what matters are the overall results. But the decisions of other people are sometimes affected by the near-term outlook, which can both spur sellers and temper the enthusiasm of purchasers who might otherwise compete with us.”
Disclosure: The author owns no stocks mentioned.
