This document outlines Warren Buffett's stock picking framework, which focuses on finding companies that:
1) Have consistently high returns on equity.
2) Avoid excessive debt.
3) Have high and increasing profit margins.
4) Have been in business for at least 10 years.
5) Have a durable competitive advantage or "moat".
6) Are undervalued based on an analysis of their discounted future cash flows.
The framework emphasizes analyzing a company's long-term performance, financial strength, competitive positioning, and intrinsic value to identify stocks trading at a significant discount to their real worth.
This document outlines Warren Buffett's stock picking framework, which focuses on finding companies that:
1) Have consistently high returns on equity.
2) Avoid excessive debt.
3) Have high and increasing profit margins.
4) Have been in business for at least 10 years.
5) Have a durable competitive advantage or "moat".
6) Are undervalued based on an analysis of their discounted future cash flows.
The framework emphasizes analyzing a company's long-term performance, financial strength, competitive positioning, and intrinsic value to identify stocks trading at a significant discount to their real worth.
Original Description:
Comprehensive guide for new investors to select top stocks and avoid poor stocks
This document outlines Warren Buffett's stock picking framework, which focuses on finding companies that:
1) Have consistently high returns on equity.
2) Avoid excessive debt.
3) Have high and increasing profit margins.
4) Have been in business for at least 10 years.
5) Have a durable competitive advantage or "moat".
6) Are undervalued based on an analysis of their discounted future cash flows.
The framework emphasizes analyzing a company's long-term performance, financial strength, competitive positioning, and intrinsic value to identify stocks trading at a significant discount to their real worth.
This document outlines Warren Buffett's stock picking framework, which focuses on finding companies that:
1) Have consistently high returns on equity.
2) Avoid excessive debt.
3) Have high and increasing profit margins.
4) Have been in business for at least 10 years.
5) Have a durable competitive advantage or "moat".
6) Are undervalued based on an analysis of their discounted future cash flows.
The framework emphasizes analyzing a company's long-term performance, financial strength, competitive positioning, and intrinsic value to identify stocks trading at a significant discount to their real worth.
December 2012 Has the company consistently performed well?
We will always looks at Return on Equity ROE to see
whether or not a company has consistently performed well in comparison to other companies in the same industry.
NPAT / Shareholders funds
Has the company avoided excess debt?
We prefer to see a small amount of debt so that
earnings growth is being generated from shareholders' equity as opposed to borrowed money.
Long term debt / Share holders
funds Are the profit margins high? Are they increasing?
To get a good indication of historical profit margins,
investors should look back at least five years. A high profit margin indicates the company is executing its business well, but increasing margins means management has been extremely efficient and successful at controlling expenses.
Net profit / Sales
How long has the company been public?
Buffett typically considers only companies that have
been around for at least 10 years. Value investing means looking at companies that have stood the test of time but are currently undervalued. Never underestimate the value of historical performance, which demonstrates the company's ability (or inability) to increase shareholder value. Do keep in mind, however, that the past performance of a stock does not guarantee future performance - the job of the value investor is to determine how well the company can perform as well as it did in the past. Determining this is inherently tricky, but evidently Buffett is very good at it. Is the company in a commodity business?
Buffet tends to shy away (but not always) from
companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity (like oil and gas).If the company does not offer anything different than another firm within the same industry, Buffett sees little that sets the company apart. Any characteristic that is hard to replicate is what Buffett calls a company's economic moat or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share. Moat Examples - Absolute advantage
The ability of a country, individual, company, or region
to produce a good or service at a lower cost per unit than the cost at which any other entity produces that good or service. Moat Examples – First mover advantage
A form of competitive advantage that a company
earns by being the first to enter a specific market or industry. Being the first allows a company to acquire superior brand recognition and customer loyalty. The company also has more time to perfect its product or service. First movers are often followed by competitors that try to capitalize on the original company's success. By this time, however, the first mover has usually accumulated enough market share, expertise and customer loyalty to remain on top. Moat Examples – Soft economic moat
A type of economic moat (or competitive advantage)
that is based on intangible qualities such as exceptional management or a unique corporate culture that breeds success. Does the company have economic moat?
The wider the moat, the larger and more sustainable
the competitive advantage. By having a well-known brand name, pricing power and a large portion of market demand, a company with a wide moat possesses characteristics that act as barriers against other companies wanting to enter into the industry. Test of good management
If a company has excess funds than what it needs for
operations, it can either buy new businesses or return the funds to the shareholders. Retained earnings should be distributed to shareholders so that shareholders can decide whether to spend on consumer items or on further investments. Retained earnings should be retained by the company only if every rupee of captial retained creates one rupee of market value for the investors. This would happen only if the capital retained would earn incremental returns equal to or above the returns available to the investors. Test of good management
If a company has excess funds than what it needs for
operations, it can either buy new businesses or return the funds to the shareholders. Retained earnings should be distributed to shareholders so that shareholders can decide whether to spend on consumer items or on further investments. Retained earnings should be retained by the company only if every rupee of captial retained creates one rupee of market value for the investors. This would happen only if the capital retained would earn incremental returns equal to or above the returns available to the investors. Test of good management
In case of X Ltd from 2007 to 2012 the total earning
per share is Rs. 40 Out of this Rs. 10 was distributed as dividends. Rs. 30 per share (40-10) was retained by the company. In this period EPS grew from 0.50 to 20.50 by Rs. 20.00. Hence 20 / 30 x 100 is 67% return in 5 years. A return of 67% would be acceptable to most investors but in the end it is the investors who have to consider whether had they received the entire amount as dividends, would they have put the money to better use. It is the ability to use the retained earnings of a company to increase earnings at a higher rate than the market which attracts investors like Mr. Warren Buffet. Test of good management
This is really just an extension of Warren Buffett’s
investment principle that one should not invest in a company whose business one does not understand. If it applies to direct investment, it also applies to indirect investment and an investor is better off investing in a company that uses its capital in areas of its own expertise. Test of good management
An investor likes to see a company grow because, if
profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. Test of good management
Earnings that are consistently increased are an
indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows. Test of good management
On the other hand, with a company whose earnings
fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions. Test of good management
Debt financing can be used to increase the rate of
return on equity. This can be misleading and also problematical if interest rates rise or fall. This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. A careful investor like Buffett would always take rates of return on total capital into account. Is the stock trading at a discount to its real value?
This is the kicker. Finding companies that meet the
other five criteria is one thing, but determining whether they are undervalued is the most difficult part of value investing, and Buffett's most important skill. To check this, an investor must determine the intrinsic value of a company by analyzing a number of business fundamentals, including earnings, revenues and assets. Is the stock trading at a discount to its real value?
And a company's intrinsic value is usually higher (and
more complicated) than its liquidation value - what a company would be worth if it were broken up and sold today. The liquidation value doesn't include intangibles such as the value of a brand name, which is not directly stated on the financial statements. Once Buffett determines the intrinsic value of the company as a whole, he compares it to its current market capitalization - the current total worth (price). If his measurement of intrinsic value is at least 25% higher than the company's market capitalization, Buffett sees the company as one that has value. Valuation of the business
1) Method - Discounted value of free cashflows
i.e. FCF1/ (1+r)^1+ FCF2/(1+r)^2…..+ FCFn/(1+r)^n 2) Discounting factor (r) - WACC 3) Free Cash flows (FCF) - This is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment. (Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt Repayment) Valuation of the business
4) WACC - A calculation of a firm's cost of capital in which
each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing. Valuation of the business Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every Rupee it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm. Valuation of the business
Cost of Equity - A model that describes the
relationship between risk and expected return and that is used in the pricing of risky securities. Cost of equity = Risk free return + Beta x ( Expected market return - Risk free return) Beta is the tendency of a security's returns to respond to swings in the market. Mr. Buffet’s quote on “Company’s track record”
Here's what we're looking for...businesses earning
good returns on equity while employing little or no debt." - Warren Buffett's letter to shareholders, 1987 Mr. Buffet’s quote on “Capital Allocation”
"Almost by definition, a really good business generates
far more money (at least after its early years) than it can use internally." -Warren Buffett's letter to shareholders, 1994 Mr. Buffet’s quote on “Employ Incremental Capital”
"The best business to own is one that over an
extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find." - Warren Buffett's letter to shareholders, 1992 Mr. Buffet’s quote on “Pay back to Shareholders”
"Most high-return businesses need relatively little
capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases." - Warren Buffett's letter to shareholders, 1992 Mr. Buffet’s quote on “Low Risk”
"...the might of their brand names, the attributes of
their products, and the strength of their distribution systems give them an enormous competitive advantage." - Warren Buffett's letter to shareholders, 1993 Mr. Buffet’s quote on “Pricing Power”
"Favored business must have two characteristics: (1)
an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume" - Warren Buffett's letter to shareholders, 1981 Mr. Buffet’s quote on “Pricing Power”
"An economic franchise arises from a product or
service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively." - Warren Buffett's letter to shareholders, 1991 Mr. Buffet’s quote on “Management”
The certainty with which management can be
evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows...The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself..." - Warren Buffett's letter to shareholders, 1993 Mr. Buffet’s quote on “Branding” Severe change and exceptional returns usually don't mix...Experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns." - Warren Buffett's letter to shareholders, 1987. Mr. Buffet’s quote on “Stability in Market share”
A fast-changing industry environment may offer the
chance for huge wins, but it precludes the certainty we seek." - Warren Buffett's letter to shareholders, 1996 Mr. Buffet’s quote on “Margin of Safety”
"An analyst can easily go wrong in estimating future
'coupons'. We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying.- Warren Buffett's letter to shareholders, 1992 Mr. Buffet’s quote on “Margin of Safety”
A too-high purchase price for the stock of an excellent
company can undo the effects of a subsequent decade of favorable business developments." - Warren Buffett’s letter to shareholders, 1982
It's far better to buy a wonderful company at a fair
price than a fair company at a wonderful price. Mr. Buffet’s quote on “Utilities, energy companies and railroads”
"We get decent returns on equity. You won't get rich,
but you won't go broke either." Berkshire Hathaway Annual General Meeting, 2009. Mr. Buffet’s quote on “Understanding of Business”
"Sometimes our own intellectual shortcomings would
stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast- moving technology is not going to lend itself to reliable evaluations of its long-term economics...We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?" - Warren Buffett's letter to shareholders, 1993 Mr. Buffet’s quote on “Understanding of Business”
In investing, one should avoid businesses whose
futures one can’t evaluate, no matter how exciting their products may be. Often the future includes competitive dynamics that would decimate almost all of the companies entering those industries.
It is not that we don't understand a technology
business or its product. The reason we don't invest is because we can't understand the predictability of the economics ten years hence." Mr. Buffet’s quote on “Businesses immune to change”
"We favor businesses and industries unlikely to
experience major change...Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride." - Warren Buffett's letter to shareholders, 1996 Mr. Buffet’s quote on “Scuttle butt research method”
"Now I did a lot of work in the earlier years just
getting familiar with businesses using the "Scuttlebutt Approach." I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, "If you could only buy stock in one coal company that was not your own, which one would it be and why? You piece those things together; you learn about the business after awhile...I have done that in the past on the business I felt I could understand so I don't have to do that anymore." - Speech at University of Florida, 1998. Mr. Buffet’s quote on “Reading of Annual Reports”
If you get interested in a company and you read the
annual report, he said, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street. Mr. Buffet’s quote on “Long term investing”
Only buy something that you’d be perfectly happy to
hold if the market shut down for 10 years The best period to hold shares is “forever”. Happy Investing !!