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What Does Warren Buffett Look Out for When Investing in Companies?

Warren Buffett is the world’s second richest man. With a net worth of US$75.6 billion, most of his wealth was created by investing in great companies. By doing so, Berkshire Hathaway Inc (NYSE: BRK.A), the conglomerate that he runs with his partner, Charlie Munger, has amassed returns of 20.8% per annum.

How does Warren Buffett do it? What are the criteria he looks out before ploughing his money into businesses?

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In his annual reports, a regular feature is the “Berkshire Hathaway Inc Acquisition Criteria”. In it, Buffett spells out the criteria that prospective firms must possess before he becomes interested in them. Investors can also use the criteria as a checklist before buying stocks.

The criteria are listed below:

“(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),

(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),

(3) Businesses earning good returns on equity while employing little or no debt,

(4) Management in place (we can’t supply it),

(5) Simple businesses (if there’s lots of technology, we won’t understand it),

(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).”

1. Large purchases

Buffett is only interested if the company in question has $75 million of pre-tax earnings at the minimum. Anything lesser, it usually gets thrown out of the window.

2. Demonstrated consistent earning power

If a business has been producing consistent profits, it means that it has a sustainable competitive advantage and has pricing power. On the other hand, commodity-like companies compete based on price alone and would not be able to produce consistency in their earnings.

3. Businesses earning good returns on equity

Return on equity (ROE) measures a firm’s profitability by revealing how much profit a company generates with the money shareholders have put in. In other words, it also reveals how a company’s management is managing the capital that shareholders have entrusted them with.

The formula to calculate ROE is:

ROE = Net Income/Shareholder’s Equity

ROE can be increased by piling on more debt. However, excessive debt can be dangerous for a company, especially when a financial crisis strikes. That is why Buffett likes businesses that are able to grow with little or no debt.

4. Management in place

Buffett loves leaders who are honest and competent. A management team that has a proven track record of success is likely to continue posting strong results in the future.

5. Simple businesses

A business must be simple to understand and within our circle of competence. Warren Buffett does not invest in a lot of industries simply because he does not understand them. Charlie Munger once said, “At Berkshire we have three buckets: yes, no and too hard.” If one does not understand a business, it should be chucked into the “too hard” bucket.

6. An offering price

Buffett acquires private firms, on top of listed companies. As such, he only entertains ideas that have a price tag attached to the business. For investors investing in the stock market, we may translate this criterion to an offering price that is lower than the intrinsic value of the company.

A Foolish takeaway

In Singapore, there are more than 700 listed companies. By using the six-point checklist provided by the Oracle of Omaha, investors can easily separate the sheep from the goats.

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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 contributor Sudhan P doesn’t own shares in any companies mentioned.