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How You Can Invest Like Warren Buffett

There’s a saying that goes “Oldies are goldies”. While I’ve often heard it used in the context of music, where some (including me – I can’t stand popular radio nowadays!) much prefer songs from an earlier generation, the particular phrase could well be used to describe shareholder letters from Berkshire Hathaway’s venerable chief executive and largest shareholder, Warren Buffett.

Back in December last year, my American colleague Dave Koppenheffer wrote an interesting article and highlighted how Buffett had actually listed down six criteria he uses to evaluate potential business acquisitions in a shareholder letter he had written some 26 years ago in 1988.

An important digression – buying shares like a business

For some context, Berkshire’s an investment holding company that houses many different businesses, the bulk of which were steadily acquired by Berkshire over the years since Buffett took control of the company in the 1960s. In addition, Berkshire also owns huge blocks of shares in other publicly-listed companies with great economic characteristics.

Over the years, the cash flow from Berkshire’s operational businesses and dividends from the shares of other publicly-listed companies it owns have provided the ammunition (i.e. a giant pile of cash) for the company to acquire yet more businesses or shares. And consequently, Berkshire’s book value per share (a key determinant of its business value) has grown by US$19 in 1964 to US$114,214 in 2013 – that’s an annual growth rate of some 19.4% for 49 years!

Buffett essentially built Berkshire into the giant it is today through masterful investing – both in terms of investing in publicly-listed companies as well as in acquiring complete ownership of private businesses. And what’s really interesting about Buffett, is his insistence that investors should invest in stocks with the mind-set that they’re investing in a whole business.

It’s for this reason that individual investors like you and me, who are looking to invest in shares of publicly-listed companies, have much to learn from Buffett’s selection-criteria for private businesses.

So, coming back to Berkshire’s 1988 letter, I dug through the company’s shareholder letter archive myself and found the list. I’ll be running the following shares through the list in a bid to demonstrate how it can be used to help us analyse investment opportunities: Raffles Medical Group (SGX: R01), Vicom (SGX: V01) and Singapore Airlines (SGX: C6L).

First criteria: “large purchases (at least $10 million of after-tax earnings)”

This criterion was chosen by Buffett as he wanted to acquire larger businesses that could “move the needle” for Berkshire’s operating results. But, it’s applicable for us individual investors as well as larger businesses tend to be able to present lesser business-based risks for investors. It’s certainly not a hard-and-fast certainty, but as rule of thumb, it more than suffices.

Company

Last 12 month’s after-tax earnings

Raffles Medical Group

S$85 million

Vicom

S$28 million

Singapore Airlines

S$401 million

Source: S&P Capital IQ

So, based on the three company’s earnings for the last 12 months, they do match Buffett’s first qualifier.

Second criteria: “demonstrated consistent earning power (future projections are of little interest to us, nor are “turnaround” situations)

This can be very applicable even when taken at face value for the individual investor. A picture says a thousand words, so the chart below could make it very clear which of our three companies have “demonstrated consistent earning power” by comparing how much their earnings have changed based on what it was 10 years ago.

Source: S&P Capital IQ

With the chart, we can tell that Raffles Medical Group and Vicom are the ones that not only demonstrated consistent earning power, they’ve also been able to demonstrate consistently growing earning power. On the other hand, Singapore Airlines – despite being part of the Straits Times Index (SGX: ^STI), the stock market benchmark in Singapore – has seen its profits swing wildly over the years.

Third criteria: “business earning good returns on equity while employing little or no debt”

It’s easy for a company to bump up its return on equity through leverage. But when you have a company earning good returns on equity (anything above 15% would be a good gauge) consistently without using too much debt, it can be a sign of a company having businesses with very lucrative economic characteristics.

Return on Equity

Company

2009

2010

2011

2012

2013

RMG

16.1%

16.9%

16.3%

15.8%

19.8%

Vicom

27.1%

25.7%

25.5%

23.9%

23.4%

SIA

7.6%

2.0%

8.1%

2.9%

3.3%

Source: S&P Capital IQ

Total debt to equity ratio

Company

2009

2010

2011

2012

2013

RMG

9.8%

7.9%

6.4%

5.1%

1.0%

Vicom

0

0

0

0

0

SIA

11.7%

9.7%

14.2%

8.3%

7.6%

Source: S&P Capital IQ

From the two tables above, it’s clear how Vicom and Raffles Medical Group have displayed consistently good returns on equity despite carrying minimal or no debt. The same can’t be said for Singapore Airlines however.

Fourth criteria: “Management in place (we can’t supply it)”

When applied to us individual investors, Buffett’s fourth criteria for acquiring private businesses could be thought of as having management with proven operational ability and a long tenure within the company or industry.

In Raffles Medical Group’s case, its executive chairman, Dr. Loo Choon Yong, was its co-founder back in 1976 and he’s still heavily involved with the future of the company. Judging from the company’s profits over the past 10 years, Loo not only has a long tenure, but also a history of good execution.

With Vicom, its chief executive Mr Sim Wing Yew, was appointed only back in May 2012, so that’s a short tenure there. Though, it must also be noted that Sim has had prior top-level managerial experience as the chief operating officer of one of ComfortDelGro Corporation’s (SGX: C52) subsidiaries, ComfortDelGro Engineering Pte Ltd, since August 2008 before becoming its chief executive in March 2011. ComfortDelGro Corporation is the majority owner of Vicom.

Mr Goh Choon Phong, the chief executive of Singapore Airlines, first joined the company back in 1990 and assumed his current position in December 2010. The airline’s profits are still erratic after Goh took over as chief executive, having swung from S$1.09 billion in the financial year ended 31 March 2011 to S$401 million over the last 12 months.

So, has Goh actually done a bad job? Not so fast. In this instance, one of Buffett’s famous quips describes the situation somewhat accurately: “When a management with a reputation or brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Airlines are indeed a tough business to operate in with bad economics.

Fifth criteria: “Simple businesses (if there’s lots of technology, we won’t understand it)”

On a broad level, Raffles Medical Group is in the business of providing healthcare services. So while its doctors and surgeons might utilise the latest medical technologies in performing their duties, the service itself would probably not be construed as having “lots of technology”.

It’s the same with Singapore Airlines, whose basic business involves the transportation of passengers and cargo by air. It’s also interesting to note that Buffett has made several high profile investments into airlines throughout his career, though most weren’t particularly successful investments.

With Vicom, there’s perhaps more technology involved. The company’s main bread and butter deals with the provision of inspection and testing services for motor vehicles as well as industries such as electronics, biotechnology, aerospace, marine and offshore, oil & petrochemical, and engineering and construction; these would all require scientific and engineering knowledge and equipment.

Sixth criteria: “an offering price (we don’t want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).”

We’re down to Buffett’s last criteria and in here, he often wants the owners of private businesses looking to sell to Berkshire to have a price ready before any talks would occur. With publicly-listed companies, we individual investors are luckier as the price is always there – it’s quoted up-to-the-minute for five days every week!

But it’s not just the price that’s important here. It’s the price we’re paying in relation to a share’s business value that’s crucial. And while using price-to-earnings ratios aren’t the alpha and omega of valuing businesses, it does provide a good gauge for investors on whether they’re getting a relative bargain when buying any particular share.

Company

Trailing price-to-earning ratio

Raffles Medical Group

22

Vicom

18

Singapore Airlines

30

Straits Times Index*

13.2

Source: S&P Capital IQ; *SPDR Straits Times Index ETF website

All three shares are priced more expensively than the market average with SIA being the most costly in terms of its PE ratio. While investors looking for bargains might balk at the higher PE ratios that both Vicom and Raffles Medical Group have, it should also be noted that the market can from time to time, award a higher valuation to businesses with very strong balance sheets (as Vicom and Raffles Medical Group both do) and consistently growing profits.

Foolish Bottom Line

While this exercise is by no means a recommendation for any of the shares mentioned, it does provide individual investors like us a framework for approaching investing in a way that’s akin to Buffett’s.

Given his phenomenal accomplishments in his career, it’ll likely benefit any investor to be able to think about investing like Buffett does.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway and Raffles Medical Group.