How do you determine whether a stock is a worthy long term investment? Here are a few questions to ask yourself before you make that next purchase.
This list comes out of the book “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor”. The book gives many examples of stocks purchased by Berkshire Hathaway and goes into detail on how Buffett would have answered these questions at the time of investment for specific investments. The book is definitely worth a read for those willing to put time in researching individual companies and who want to explore this topic further.
1.) Does the company have an identifiable durable competitive advantage?
We have gone into expensive detail recently on identifying companies with a durable competitive advantage here on BeginToInvest recently. See some of our recent posts :
- 9 signs of a Competitive Advantage: http://begintoinvest.com/9-signs-competitive-advantage-9-one-buffetts-favorites-look/
- Investing Book Series: “Competitive Strategy” Chapter 1: http://begintoinvest.com/investing-book-series-competitive-strategy-chapter-1-and-using-it-to-find-your-next-great-investment/
- Investing Book Series: “Competitive Strategy” Chapter 2: http://begintoinvest.com/investing-book-series-competitive-strategy-chapter-2-strategies-to-outperform/
A durable competitive advantage means the company has a leg up over its competitors. Maybe it is because of strong brand awareness, a cost advantage over competition, or because the company sells a truly unique product. Think companies like Heinz Ketchup or Coca-Cola (brand awareness) or GEICO insurance (low cost provider). It should be no surprise that Buffet owns or controls large stakes in each of these companies.
2. Do you understand how the product works?
“If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.”
Obviously this doesn’t mean you have to be an expert in the industry, it just means you better be able to explain how the company makes money and the process involved in creating, selling and using the company’s product.
Consider Norfolk Southern Company (Ticker: NSC). Norfolk Southern operates one of the largest rail lines on the east coast of the U.S. and transport a large percentage of the coal from the eastern U.S. to ports on the east coast for shipments across the Atlantic.
I can tell you exactly how they make their money: By driving a train with product from point A to point B.
Think about a couple of questions:
– Who is the company’s customer?
– Why do their customers choose this company?
– How much do customers pay for the service?
Understanding these basic questions means being able to evaluate the company’s place in its industry and evaluate whether it is maintaining its competitive advantage.
3. If the company in question does have a durable competitive advantage and you understand how it works. What are the chances that it will become obsolete in 20 years?
When you invest in a company today, you need to be investing with the idea of holding that investment forever. Long term investing in solid companies allows for management to compound its profits and shareholder equity year after year. Over long periods of time this will result in significant capital appreciation of your investment.
If you can’t put forward an honest guess on how the company will make its money in the future, don’t be afraid to take a pass on investing in that company. We discussed Norfolk Southern above, is there any doubt what their business model will be 20 years from now? They will be operating on the same rail lines today, probably transporting the same product to the same customers as it is doing today.
Compare this with a company like Facebook (ticker: FB) or Google (Ticker: GOOGL) who have been on spending sprees lately. Facebook has invested tens of billions of dollars in instant messaging companies and virtual reality. Google has spent billions acquiring companies in robotics, home thermostats and phone hardware.
Facebook makes some money from ads on its users news feeds, how does instant messages that disappear after reading (Snap Chat) and Virtual Reality fit in with that? I’m not sure.
Not being able to understand Facebook’s business model makes it extremely hard to confidently value the company, which makes it extremely difficult to determine if it has long term value.
4. Does the company allocate capital exclusively in its realm of its expertise?
Very similar to question #3 above. Is the company focusing on what has made it successful in the past?
In previous posts about identifying companies with a competitive advantage, we have looked at the company Clorox (Ticker: CLX). They make all sorts of cleaning supplies, and have stuck with the business model successfully for decades.
If they announced tomorrow that they were spending $20 billion on developing kitchen furniture, how do you think that would make investors feel? Entering a new industry means tons of investments in new equipment, research, advertising, etc.
Clorox has been very good at using its retained earnings to invest back into the company and generate higher future returns (See #6 below on how to measure this). If Clorox were to enter a whole new industry, I would be willing to bet they would not be able to generate as high of a return on investment compared to if they continued to do what they have been doing for decades.
5. What is the company’s per share earnings history and growth?
Look at about 10 years of the company’s historical earnings. Are the earnings strong, relatively consistent and on an upward trend?
Compare the historical earnings of two companies, General Mills (Ticker: GIS) and General Motors (Ticker: GM).
What company would you be more willing to bet has positive earnings in 2024? 2034?
General Motors has had years where they have made many billions of dollars, but they have also had periods where they take tremendous losses (and as in 2009, where they declared bankruptcy and wiped out every penny of investors’ dollars).
A history of strong consistent earnings gives investors confidence in allocating their savings to a company and gives confidence that the company will continue to have an appreciating share price.
6. Is the company consistently earning a high return on equity?
Return on Equity (ROE) is calculated by:
For much more detail on ROE, see our definition page here: http://begintoinvest.com/definitions/return-on-equity-roe/
Return on Equity measures how effectively management is using the company’s capital to generate profits.
A strong, consistent history of high Return on Equity means that the company will continue to grow earnings, shareholder equity and therefore hopefully appreciate its stock price as well.
Consider a few companies below. Can you guess the two that Buffet is invested in?
In general, a ROE above 15% is considered strong, but it is as important (if not more important) that the ROE figure is consistent as well.
A company with a competitive advantage is able to consistently compound its earnings growth which in turn hopefully gives investors consistent compound growth in their portfolios.
7. Is the company conservatively financed?
To determine how a company is financed, look at the company’s Balance Sheet. Take a look at a few specific lines; Current Liabilities, Long Term Debt and Total Liabilities.
How does the company’s debt relate to its historical earnings? Is it possible for the company to realistically pay of the debt?
Buffett likes to see a company with no more debt than 3 years of average historical earnings.
Consider a few companies in the news today:
Why is this important? A company with a strong competitive advantage shouldn’t need to take on loads of debt to finance the company’s operations. A successful business should be able to generate the profits needed to keep the company running. If a company is not able to fund its operations, it should serve as a sign for investors to proceed with caution.
By the way, hopefully it is becoming apparent why some of the previous questions are important. When investing in a company with debt to repay, it is imperative that you know whether or not the company will be able to repay the debt, because if it can’t, you can expect your investment to go to $0.
This is why historical earnings, ROE and other figures are so important, because it all comes together to paint a picture of how the company operates and its potential value for investors.
8. Is the company actively buying back shares?
When a company buy back its own shares, it means less shares “Share the pot” of earnings and dividends when the end of the quarter or year-end comes. It also means investors get to own more of the company for no additional investment.
Consider investing $10,000 in a stock of a company that has 100,000 shares outstanding and a $1 million market cap (therefore the price per share is $10- and your investment buys 1,000 shares)
That $10,000 represents 1% of all shares outstanding. You now own 1% of this company.
Let’s say this year the company earns $100,000 in net income (or $1 per share in earnings, or EPS).
Next year the company buys back half of the shares outstanding in the company, now only 50,000 exist. And this next year the company earns $100,000 in net income again.
This next year, the company reports $2 in earnings per share ($100,000 / 50,000).
So, without the company earning an additional penny, the investor’s shares are responsible for double the EPS!
And now this investor who once owned 1% of the company now owns 2% (10,000 / 50,000) of the company….without investing another dollar!
In this situation, the shareholder should be seeing an increase in the value of their shares because each share represents a larger portion of the company, and a larger portion of the company’s profits.
To determine if a company is buying back its shares, look in two places:
– The company’s Statement of Shareholder Equity, or the Shareholder Equity section of the balance sheet. Look for “Treasury Shares”, which are shares that the company has bought back and retained on the balance sheet.
Consider Proctor and Gamble’s (Ticker: PG) most recent balance sheet:
– Recent 10-K’s for announcements of share buybacks.
Here is the text straight out of PG’s most recent 10-k:
If a company has the money to consistently buy back its own shares over time, it is a sign that the company possesses a strong competitive advantage.
Investors in companies that buy back large amounts of shares should ultimately see increases in the value of their shares as fewer and fewer outstanding shares remain and earnings per share amounts rise.
9. Is the company free to raise prices with inflation?
Inflation increases costs for the company and eats away at a company’s margins. In highly competitive industries, companies may not be able to pass along price increases to their customers for fear of losing market share.
Over time, this will lead to a situation where it may cost the company more money to produce a product than what it can sell it for…..not a good scenario for a business!
To determine this, find a company’s historical profit margins. Do they remain consistent?
Companies like Coca-Cola (Ticker: KO) have been able to raise prices as costs for ingredients rise, leading to consistent profit margins. Compare this to a company like American Airlines (Ticker: AAL), which is in a highly competitive industry and may not be able to raise ticket prices as jet fuel prices rise.
A company with a strong competitive advantage will have no problem maintaining profit margins (and therefore earnings, ROE, etc.).
10. Are large capital expenditures required to update plant and equipment?
If a company is forced to constantly update its equipment and technology it is not able to use that money to buy back shares, add to its retained earnings or give to shareholders as a dividend. It also means the company is in a highly competitive industry and may become obsolete (see question #2) if it does not out-spend its competitors in R&D.
Compare this to a company that we talked about earlier, Clorox, who spends approximately 2% of its revenue on R&D (Intel spends about 20%!). This means for every $1 that comes in to Intel, 20 cents must go to immediately updating equipment, and finding out how to improve its products faster than their competitors.
Clorox doesn’t have that problem. It spends only 2 cents per $1 in revenue on R&D. Its cleaning solutions will probably remain very similar for decades to come, and therefore can afford to immediately give money back to shareholders or buy back its stock.
A lot of time should be spent researching before you invest in individual companies. Being able to answer these questions ensures that you know what you are investing in, and ensures that the company has a history of capital appreciation and shareholder return.
For those interested in finding out how to determine these answers in much more detail, consider the book “The New Buffetology”, which takes 270+ pages explaining all the calculations to determine the answers for the questions above and gives tons of examples on specific companies and specific investments Buffett has made in the past. At the time I write this, used copies are under $2 on amazon: