Wednesday, October 12, 2005

Stocks selection: Warren Buffett's criteria

In his book, The Essential Buffett, Robert G. Hagstrom listed down twelve basic principles that guide Warren Buffett investments decisions.

It can be organized in four areas:
a. Business
b. Management
c. Financial
d. Market

Warrent Buffett's twelve investment principles

On Business

1. He invests only in the businesses that are simple and understandable

Hagstrom wrote, "...he purposely limits his selections to companies that are within his area of financial and intellectual understanding..." because otherwise " cannot possibly interpret developments accurately or make wise decisions." and that "...the key (for a business) is to do those ordinary things exceptionally well."
An investor needs to do very few things right as long as he or she avoids big mistakes. - Warren Buffett

2. With consistent operating history

Buffett avoids purchasing companies that are either changing directions due to past failures or going through a difficult time. " returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors."
Severe change and exceptional returns usually don't mix. - Warren Buffett

3. With favourable long-term prospects

Buffett prefers businesses with pricing power. Such pricing power usually comes from products differentiation. To Buffett, commodity businesses, (i.e. oil, gas, chemical, lumber, and even computers, automobiles, airline services, etc.) that has no meaningful product differentiations therefore lacking pricing power, are not worth purchasing.

The companies with pricing power, called "franchise" business, provide products or services that
a. is needed or desired,
b. has no close substitute, and
c. is not regulated.
(i.e. consumer products,

"This pricing flexibility...allows them to earn above average returns on invested capital."

The key question on long term prospect is therefore whether a business has pricing power through product differentiation. "A franchise can survive inept management; a commodity business cannot," Hagstrom wrote base on comments from Buffett.

On Management
(details coming soon...)
4. Is management rational
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?

On Financial

7. Focus on return on equity, not earnings per share
8. Calculate "owner earnings"
9. With high profit margins
10. Achieve more incomes (will reflect in market value) with less capital (retained profit)

On Market

11. Determine value of the business
12. Buy the business cheap