Warren Buffett's knack of spotting potential early is legendary. It has made him one of the most successful stock investors of all times. How does he manage to identify multibaggers? What is the secret mantra that he follows to pick winners? Actually, it's no secret.
Buffett's stock picking is based on a strict conservative philosophy that he has followed for decades. He prefers to invest in businesses, which manufacture products that people can't or don't want to live without, such as toothpastes, soaps, soft drinks, cars and computers. The companies that are given to speculation or hype are often disregarded.
Buffett's primary concerns include a company's financial stability, quality of management and simplicity of business. He also checks whether the company has the ability to pass on its costs to its customers. He believes that a company should be able to adjust its prices to inflation because it enables it to make profits in varying economic climates. There is another critical quality that Buffett looks for in a company, the enduring moat.
This is the USP of a company, the one quality that makes it almost impossible for its competitors to overtake it regardless of how much money they are willing to spend. Coca-Cola, whose stock is a long-time holding of Buffett's company, Berkshire Hathaway Investments , is a good example of the enduring moat. Coca-Cola is such a recognisable brand that it is difficult to imagine a new company being able to dislodge the market leader regardless of how much money it might be willing to spend on advertising and brand building.
The oracle of Omaha is now on the prowl in the Indian markets. Last week, he told reporters in Bangalore that he was "a retard to have come to India so late". Even as he trawls the markets for winners, we decided to run the very filters that are used by the guru to find out which Indian companies can pass his muster. Let us look at the seven fundamental parameters Buffett uses to zero in on potential stocks in the US. We will then use the same to identify the Indian companies that are worth investing in.
STABILITY OF EARNINGS:
This can be checked by considering the earnings per share (EPS) for the past 10 years. EPS is derived from the residual profit left after payment of all expenses, taxes, depreciation, interest, preference dividends and belongs entirely to equity shareholders. A company should not have a negative EPS in the past 10 years. If the EPS is lower than that in the previous year, the dip should not be more than 45%.
DEBT TO EARNINGS RATIO:
The second variable is the level of long-term debt to earnings ratio. Buffett likes conservatively financed companies. He prefers the long-term debt of a company to have been paid off from its net earnings in less than five years. This implies that the long-term debt to earnings ratio should be less than or equal to five.
RETURN ON EQUITY (ROE):
The third variable measures how much money a company earns on its equity. The ratio is generally expressed as a percentage. For a company to figure on Buffett's radar, its 10-year average ROE should be greater than or equal to 15%.
Buffett's stock picking is based on a strict conservative philosophy that he has followed for decades. He prefers to invest in businesses, which manufacture products that people can't or don't want to live without, such as toothpastes, soaps, soft drinks, cars and computers. The companies that are given to speculation or hype are often disregarded.
Buffett's primary concerns include a company's financial stability, quality of management and simplicity of business. He also checks whether the company has the ability to pass on its costs to its customers. He believes that a company should be able to adjust its prices to inflation because it enables it to make profits in varying economic climates. There is another critical quality that Buffett looks for in a company, the enduring moat.
This is the USP of a company, the one quality that makes it almost impossible for its competitors to overtake it regardless of how much money they are willing to spend. Coca-Cola, whose stock is a long-time holding of Buffett's company, Berkshire Hathaway Investments , is a good example of the enduring moat. Coca-Cola is such a recognisable brand that it is difficult to imagine a new company being able to dislodge the market leader regardless of how much money it might be willing to spend on advertising and brand building.
The oracle of Omaha is now on the prowl in the Indian markets. Last week, he told reporters in Bangalore that he was "a retard to have come to India so late". Even as he trawls the markets for winners, we decided to run the very filters that are used by the guru to find out which Indian companies can pass his muster. Let us look at the seven fundamental parameters Buffett uses to zero in on potential stocks in the US. We will then use the same to identify the Indian companies that are worth investing in.
STABILITY OF EARNINGS:
This can be checked by considering the earnings per share (EPS) for the past 10 years. EPS is derived from the residual profit left after payment of all expenses, taxes, depreciation, interest, preference dividends and belongs entirely to equity shareholders. A company should not have a negative EPS in the past 10 years. If the EPS is lower than that in the previous year, the dip should not be more than 45%.
DEBT TO EARNINGS RATIO:
The second variable is the level of long-term debt to earnings ratio. Buffett likes conservatively financed companies. He prefers the long-term debt of a company to have been paid off from its net earnings in less than five years. This implies that the long-term debt to earnings ratio should be less than or equal to five.
RETURN ON EQUITY (ROE):
The third variable measures how much money a company earns on its equity. The ratio is generally expressed as a percentage. For a company to figure on Buffett's radar, its 10-year average ROE should be greater than or equal to 15%.
RETURN ON TOTAL CAPITAL (ROTC):
This variable can sometimes give an incorrect picture. It's because some companies have a high debt content in their capital structure in relation to their equity. Still, they will show a high ROE because of the low equity base. However, a high debt content makes the company risky as the debt needs to be serviced, irrespective of the company being profitable or not. ROTC overcomes the limitation of ROE. Buffett prefers the companies whose 10-year average ROTC is greater than or equal to 12%.
FREE CASH FLOW:
Buffett does not pick stocks of companies that indulge in major capital expenditure. Free cash flow is the difference between operating cash and capital expenditure. Therefore, free cash flow should be a positive. A company with a positive free cash flow is generating more cash than it is consuming and this is a good sign.
RETURN ON RETAINED EARNINGS:
The next variable is the return on retained earnings. Buffett uses this to assess the management's performance. The variable gives an indication of the ability of the management to use retained earnings for shareholders' wealth creation. To be eligible for investment by Buffett, a company's 10-year return on retained earnings should be greater than or equal to 12%.
After we applied these six filters, we zeroed in on 45 companies. Buffett uses one more filter while identifying companies, market share. He prefers the companies that have an overwhelming market share and are dominant players in their fields. Market share is an important consideration because it ensures sustained profits for the company. BASF India and ONGC have a staggering market share of 98% and 85%, respectively, in their industries. In the past 10 years, these two companies have delivered annualised returns of 21.7% and 28.6%, respectively, in comparison to 17.58% returns generated by the BSE Sensex.
A caveat is in order. Buffett is also a strong proponent of the 'buy and hold' strategy. He does not buy a company's shares for a week, a month or even a year. He likes to remain invested for a very long term. Small, day-to-day stock market movements don't bother him too much. Therefore, if you want to follow his investments, you must also copy his strategy. It suits only the long-term investors. Short-term to medium-term investors may not derive adequate benefits if they follow in Buffett's footsteps.
The Warren Buffet stock selection guide
Look for companies with commanding market shares.
Make sure that the company has a long history of increasing EPS.
Ensure that the company has been conservatively financed.
Assess the management performance by evaluating ROE, ROTC and return on retained earnings.
*From the book titled The Guru Investor by John
P. Reese, published by John Wiley & Sons, Inc.
