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Warren Buffet

Every year Warren Buffet, the famous investor who runs Berkshire Hathaway Inc. (NYSE:BRK.A Trend), issues a letter to their shareholders. These letters offer a unique opportunity to peer into the mind of arguably one of the best investors of all time. The 2014 letter, dated February 27, 2015 was of particular interest because it marked the 50 year anniversary of the company.

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These letters are long, but worth the read as they offer a variety of valuable information that can make you a better investor. The 2014 letter can be read here, and you can see previous year’s letters here.

As I read the letter a lot jumped out, but of particular interest was Berkshire Hathaway Inc.’s acquisition criteria found on page 23. The company is known for its ability to buy great businesses that lead to market beating returns, so naturally I wanted to compare what they do to my own investment strategy. The following is a quote from the letter that shows their six criteria.

BERKSHIRE HATHAWAY INC.

ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

(1)        Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),

(2)       Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),

(3)       Businesses earning good returns on equity while employing little or no debt,

(4)       Management in place (we can’t supply it),

(5)       Simple businesses (if there’s lots of technology, we won’t understand it),

(6)       An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

Berkshire is a huge company, so for the purchase of a business to have an effect on the bottom line, they need to buy companies of a certain size. As an individual investor and not a huge company the first point won’t apply, but the other five definitely do. Let’s dig into criteria two to six.

(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations)

When I invest I look for companies that have the ability to make more and more money over time. Part of this identification process will usually involve looking at the past 10 years of earnings. Ideally I like to see steadily increasing profits over the decade. I am a dividend growth investor looking to utilize a growing stream of dividends as an alternate source of income in retirement. It is very important that the companies I invest in have the ability to grow their earnings year after year so that they can increase the dividend in a sustainable way.

Related article: 14 Canadian Dividend Growth Companies with Consistently High Earnings Growth

I found it interesting that they place no interest in future projections and turnaround stories. It makes sense to look for a company that has already proven its earning power. This is similar to the reason I invest in companies with long dividend streaks. Ideally I’m looking for 10 years of consecutive annual dividend increases from a company before I will invest. If the company is Canadian I’m a bit more lenient as we have fewer companies than the US to choose from. I want to see that the company has been able to adapt in a changing environment over the past decade while increasing the dividend. Prove it to me first, and then you can have my money.

It seems like Mr. Buffet and I are on the same page here. Good news so far.

(3) Businesses earning good returns on equity while employing little or no debt

Warren Buffet is famous for buying great companies at fair prices. Part of a great company is a sustainable competitive advantage or wide moat. It is a hard thing to assess quantitatively, but return on equity (ROE) is one measure that can be used as an indicator of a wide moat. If the company has been able to consistently maintain a ROE above the industry average, it suggests that they have wide moat.

When I invest I am looking for companies that have a consistent or growing ROE that is above the industry average. This will range from industry to industry, but if they have ROE around 20% or higher than it is generally a good sign. ROE can be manipulated to a certain extent which is why I like to look at return on invested capital (ROIC) as well. If the ROIC and ROE are around the same then this is an indication that ROE is reliable.

The second part of this point “little or no debt” is a very important one. I invest for the very long term, so why would I want to risk my money in a company that could get into financial trouble in the future. I want a financially strong company that is poised to survive an unpredictable future. Financial strength can be assessed using a variety of measures. Little or no debt is a good start, but there are other factors to look at too. If you are interested you can read more about how I assess financial strength here.

(4) Management in place (we can’t supply it)

Berkshire owns a lot of different companies and Warren Buffet can’t run them all personally, so it makes sense that he wants management in place already. Also the companies he invests in are usually great companies. To get to “greatness” status the management usually has to have performed well, so why would you want to mess with it. The phrase “If it aint broke, don’t fix it” comes to mind.

I like to invest in a company with good management that has proven its ability to perform well, but I find it hard to accurately assess management. Often I’ll rely on the company’s results to see if it has performed well, but this isn’t really an in depth look at management. It is me assuming that because the company performed well, management did too. I think this is a fair assumption, but you know what they say about making assumptions.

Other signs that management will be good in the future can be high insider ownership and compensation packages that are aligned with shareholder values and the long term plans of the company. Morningstar has a stewardship rating and provides some opinions on management that I’ll review, but beyond what I’ve already mentioned and reading about the company I find it hard to assess management. This is one area that I should probably spend some more time learning about.

Before you invest how do you assess management, or do you at all?

(5) Simple businesses (if there’s lots of technology, we won’t understand it)

It is common sense, but often ignored. If you don’t understand it, why are you investing in it? When I invest I want an understanding of how the company makes their money. Without this understanding it is unreasonable to suggest that you will know when to sell the stock or buy it. For the most part I’m a buy and hold investor, but I have a set list of situations where I’d consider selling a stock. One of them is if the business fundamentally changes for the worse. If I don’t understand the business how will I know if or when it has fundamentally changed?

Related article: In What Conditions Would I Consider Selling A Stock?

(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

I invest in the stock market because I don’t have the type of money to be able to buy businesses outright. With the stock market there is always a price, so this point doesn’t really apply to me. That said price is still very important to me. I like to invest in companies at a fairly conservative price based on multiple valuation methods targeting historically low valuations. This is a little different of Mr. Buffet’s strategy of buying great companies at a fair price. It is hard to say what his definition of a fair price is or how he calculates, but I am comfortable with how I determine my target buy prices for now.

My investing practice involves identifying great dividend growth companies and then waiting for the stock price to drop to a fairly conservative price before buying. This usually involves a fair amount of patience. This is similar to Warren Buffet’s investing style but he doesn’t limit himself to dividend growth stocks and he is MUCH more experienced than I.

Summary

After going over these points it was nice to discover that I am probably on the right track, but I should consider spending more time reviewing management than I normally do. My investing style has some similarities to how Berkshire Hathaway Inc. and Warren Buffet buy businesses, but at the end of the day it is very unlikely I’ll be able to reach anything close to his performance. As noted on the first page of the 2014 letter to Berkshire’s shareholders, the company’s performance from 1964 to 2014 in per share market value was 1,826,163%, a compound annual gain of 21.6%. Not bad at all!

 

Photo credit: bunnicula / Foter / CC BY-ND

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4 Comments

  1. I just finished reading it. What a legendary cool dude Warren Buffet is. Everything he says make total senses to me and I want to follow every single advice of his. Hope his health is great for a long time as I want to see him as long as I invest. Thanks for your posting.

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