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Tuesday, May 3, 2011

How Warren Buffett decides which Stocks or Companies to Buy?

12 Important Questions: How Warren Buffett decides which stocks or companies to buy.

1. Is the business simple and understandable?

Buffett will not invest in a business he can not understand, which is one of the reasons he avoided technology stocks even during the boom of the late 1990s. If you understand a business, you have a better chance of seeing opportunities and problems before they arise.

2. Does the company has a consistent operating history?

Although past performance is no guarantee of future results, it does show whether a business can operate in a variety of business conditions.

3. Does the business have favorable long-term prospects?

This may seem like a no-brainer, however Buffett believes in holding good companies for the long term and that meant seeing a clear future. Companies that operated on trends, fads and technology that is out of date tomorrow didn’t fit his model regardless of how profitable they were in the short run.

4. Is the management rational?

Buffett places a great deal of importance on management and one of the areas he focuses on is how excess cash is used. If the company can generate above average returns by reinvesting the cash in the business it should do so because this builds shareholder value. However, if not the management should return the cash to shareholders. In other words, the decision should be rational.

5. Is the management candid with shareholders?

Although strides have been made in opening company books, Buffett believes that many company executives still hide behind accounting conventions and don’t fully report to shareholders. He admires managers that admit mistakes and take responsibility for the company.

6. Does management resist the institutional imperative?

Buffett describes the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. Call it peer pressure for CEOs.

7. What is return on equity?

Buffett focuses on return on equity rather than the more popular earnings metric in evaluating companies. His rationale is that earnings are fleeting and can be manipulated. Long term, return on equity will have a more profound effect on the company’s fortune than earnings.

8. What are the company’s “owner earnings?”

Buffett uses a rough calculation that replaces the traditional cash flow calculation to give him a clearer picture of company value. His calculation includes estimates of future capital expenditures, something missing in cash flow calculations.

9. What are the profit margins?

If a company can’t convert sales into profits, it has obviously failed. One of the ways this happens is to keep expenses to a minimum. Buffett avoids companies with bloated expenses because it reflects a lack of discipline even if the company is profitable – it would be more profitable if expenses were always controlled.

10. Has the company created at lease one dollar of market value for every dollar retained?

Buffett notes that this is the test of correct capital allocation. Has the company correctly use capital to created market value (shareholder value) with cash it retained? If the company is holding on to cash, but not creating value for shareholders, what’s the point?

11. What is the value of the company?

Buffett says the value of a company is simply the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate. This model differs from most you’ll find because it depends on being able to predict earnings for the life of a company. Buffett says if you pick company that has the attributes mentioned above, you can do this.

12. Can it be purchased at a significant discount to its value?

This is pure Buffett and where he gains his margin of safety. By buying at a discount, he knows that even if he is off somewhat of his evaluations, the discounted price will cover the difference. However, my guess is he doesn’t need that margin very often.

Can you duplicate Buffett’s success? Probably not, but there are valuable lessons here for us all.

Source: “The Warren Buffett Way” by Robert Hagstrom. Published by Wiley Books.