While Buffett may not use all of them for every investment, these common attributes consistently surface as guidance for his choices.
The four tenets are: Business, Management, Financial and Market.
As a long-term investor seeks to park his money in a business without having to worry if it’ll still be around tomorrow, it is crucial that he understands the business itself.
To quote Albert Einstein: If you can’t explain it simply, you don’t understand it well enough. A simple test would be explaining it to someone who knows nothing about the business.
The business should be consistently profitable. This can be checked by looking at its past financial performance for sustainable growth in its top and bottom lines.
More importantly, it should continue to be profitable. This will require judgement on the outlook of the industry as well as the company.
In life, we surround ourselves with people whom are honest and sensible and we trust their judgement because we believe they have our well-being at heart. In business, the same concept applies when choosing a management team.
We know that all businesses go through phases of good and bad. While it’s easy for management to deliver positive news, it’s tough for them when the company is not performing. This is where candor is prized. A management team that is willing to tell you the truth, despite the difficulties faced.
We want a management team that is logical in their decisions, particularly if it goes against the grain of the general view, but is beneficial to the company in the long run.
Firstly, one key difference is the focus of profitability, the book suggests an emphasis on return on equity, over earnings per share.
As a company makes a profit, any balance after deducting dividend payments is kept as retained earnings in equity. This means that earnings base for next year has increased.
Buffett does not see anything phenomenal about a company that has increased its earnings by 10 percent, if its earnings base increased by the same amount. It’s akin to compounding interest in a savings account.
Return on equity on the other hand, shows how well a firm’s management is able to generate a return on its operations from the capital at hand.
Secondly, we fall back on the basic profit margins. Simply put, the higher the margins, the higher profit the company is able to extract out of each dollar of revenue.
Next, Buffett prefers owners’ earnings compared to cash flow. To calculate the former, we take net income, add depreciation, minus capital expenditure (capex) and additional working capital.
The difference between the two formulas is capex. Buffett argues that a company that does not make the necessary capex will surely decline. Thus, he views it as a critical component to assess the owners’ actual earnings.
Last in the line of financial tenets, we must question if the company is able to deploy its retained earnings profitability. If a company’s retained earnings go up by $1 per share, the market value should also go up by at least $1.
If the company is able to earn more than $1 on that dollar, the market will likely price it higher as well. If it is unable to do so, then the firm’s shareholders will be better served if the company pays out the earnings via dividends instead.
Last but not least, we should derive an estimated value of the business. Value and price are not to be confused, value is what you get, price is what you pay.
Buffett, the star pupil of Benjamin Graham, the late father of value investing, stressed a need for margin of safety when purchasing a stock. This is the difference between the value and price of a business.
After all, overpaying for a business does not provide an investor with sufficient room for manoeuvre. Even if it satisfies the first three tenets, we must be ready to admit that we may be wrong and share price could go against us.
A large margin of safety allows one to exit the stock, hopefully, without much capital loss.
Next up, we’ll go through a case study by assessing a company using these four tenets.
Disclaimer: All information is credited to the book “The Warren Buffett Way” and its author, Robert Hagstrom.