Are you prepared, with a plan, to act the next time the stock market slumps? In chapter 13 of “The New Buffettology,” Mary Buffett and David Clark lay out a checklist of Warren Buffett (Trades, Portfolio)’s criteria for making investments when the market surrenders to the bears, his so-called "10 Points of Light."
First, though, the guru is prepared:
- He has a working knowledge of several hundred companies with competitive advantages.
- He has a game plan that describes what he will do when everyone else is panicking.
With those pieces in place, Buffett works through the screening process using these 10 criteria:
- Return on shareholders’ equity: Also known as “book value,” this metric is defined as “a company’s total assets minus its total liabilities.” The number can be found by reading a company’s balance sheet, whether quarterly or annually. Writing in 2002, the authors said the market’s annual return on shareholders’ equity averaged 12% over the previous 50 years. Buffett would look for returns above that average and expect to find them among companies that have durable competitive advantages.
- Return on total capital: This differs from return on shareholders’ equity because it includes non-equity sources of capital, including debt. The authors noted that return on shareholders’ equity can be misleading because of share buybacks and other factors; for example, over one 10-year period, General Motors (GM, Financial) generated an average return on equity of 27.2%, but its total return on capital averaged 9.5%. To make sure he doesn’t allow himself to be misled, Buffett wants “consistently” high rates of return on both equity and total capital.
- Historical earnings: The guru wants to own businesses showing consistent earnings power, consistency being a good indicator of durability. Historical inconsistencies suggest that management may not be doing a good job. Investors who want to pick stocks like Buffett must find stocks with a durable competitive advantage as well as strong, consistent and growing earnings.
- Debt: The authors wrote, “Warren has found that a company with a durable competitive advantage spins off a lot of cash and has little or no need for debt. [On the other hand], Companies in a price-competitive business often need to upgrade their plant and equipment or to develop new products to stay ahead of the competition and thus require lots of long-term debt to fund product enhancement or diversification.” He will bend this rule at times, for financial companies and when debt is used to buy another company at a fair price.
- Products and services: As discussed in previous chapters, Buffett considers it essential that a business have a brand name or a key service on which people depend. For example, would the stores that sell this product lose sales if they did not carry this brand name? As a further test of its durable competitive advantage, do consumers repetitively buy it? The classic example of this, of course, is King Gillette’s discovery that he could sell razors at a discount and make a lot of money repetitively selling blades.
- Organized labor: Although unions are steadily losing ground now (except for government workers), they have had a strong presence during much of Buffett’s career. The authors report this is especially true for companies that invested heavily in capital equipment and have high fixed costs (the airline industry, for example). The authors put it bluntly: “Seldom will you find a durable-competitive-advantage company with an organized labor force.” Part of that reflects the ability of companies with such advantages to pay higher wages and to withstand strikes if they do occur.
- Pricing, low demand and inflation: For a price-competitive company, low demand or overproduction may force it to reduce prices, and the cost of production may exceed the price available; again, the airline industry was an example. Similarly, a company needs the freedom to match the rate of inflation (which was a chronic problem through much of second half of the 20th century); durable companies have that, price-competitive companies do not.
- Operational costs: At issue is the amount of retained earnings needed to maintain operations. Money used for operational maintenance is not available to shareholders or to reinvest for future earnings. For instance, H&R Block (HRB, Financial), which had a durable competitive advantage, earned $17.14 per share between 1989 and 1999. Of that amount, $9.34 went to shareholders as dividends, leaving $7.80 per share to increase its equity base. Over that same time, H&R Block was able to increase its earnings per share from $1.16 to $2.56, or more than double them.
- Share buybacks: Buffett also expects that a company with a durable competitive advantage will have a long history of repurchasing shares. Doing so indicates the company has “an abundance” of cash. On the other hand, price-competitive businesses rarely buy back shares and often issue new shares, thus diluting the stock of existing shareholders. When Buffett takes a major stake in a company, as he usually does, he recommends that the board of directors increase their share repurchase programs. When they do so, they reduce the number of shares outstanding, which means he effectively increases his ownership stake without investing more.
- Growing market value: Buffett has shown he can walk the talk. Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) had a book value of $975 per share in 1983. By 2001, that had increased to about $40,000 per share, an increase of slightly more than 4,000%. At the same time, the trading price increased from around $1,000 to $68,000, a massive win by any measure (in September 2018, it was trading for about $332,000 per share). The authors wrote, “Warren believes that if you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company’s stock.”
In winding up chapter 13, we note the first step to investing like Buffett is to be prepared with your list of stocks and then to take the 10 screening steps listed above. What’s remarkable in all of this is its simplicity. There are no secrets, no special formulas or any magic, just plain old gumshoe sleuthing and discipline.
About
Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
