Would Warren Buffett Be Interested in Sinopec Shanghai Petrochemical Company Limited, One of the 30 Best Stocks in Singapore for 2018?

My Foolish colleague, Chong Ser Jing, recently ranked all the stocks in the Singapore market according to the Magic Formula, an investing strategy popularised by Joel Greenblatt in his book, The Little Book That Beats The Market. Ser Jing wanted to find the 30 best stocks in Singapore for 2018, based on the Magic Formula, and Sinopec Shanghai Petrochemical Company Limited (SGX: K3DD) happened to be one of them.

Sinopec is one of the largest integrated petrochemical companies in China. Its main products fall into four categories of refined oil products, petrochemicals, synthetic resins and synthetic fibre polymers, and synthetic fibres. Sinopec is trading as an American Depository Receipt on Singapore’s stock exchange.

Even though Sinopec was ranked highly on Greenblatt’s Magic Formula, would one of the greatest investors in the world, Warren Buffett, be interested in the company? We can’t ask him in person, but we can turn to a six-point acquisition criteria formulated by the Oracle of Omaha to give us some clues to answer the question. However, more importantly, Buffett’s checklist, together with a deep dive into Sinopec’s financials that I did recently, can help investors develop a better understanding of the company.

With that, let’s turn to Buffett’s acquisition criteria.

1. Pre-tax earnings of at least US$75 million

Buffett has this criterion in place because the conglomerate he controls, Berkshire Hathaway, is a near-US$500 billion behemoth, so his acquisition targets need to be of a certain size to move the needle for Berkshire.

In 2017, Sinopec had pre-tax earnings of around RMB 7.9 billion (approximately US$1.3 billion), which meets the first criterion.

2. Demonstrated consistent earning power

The second criterion helps Buffett determine if a company has a stable and/or growing business. Companies that have a history of steady and growing earnings tend to have competitive advantages that help their businesses improve over time.

The table below shows the net profit for Sinopec over the past five years:Source: S&P Global Market Intelligence

Sinopec went into a loss in 2014. Other than that, its earnings had increased consistently from 2013 to 2017. In all, the company’s net income had grown at an annualised rate of 32.3% for the time frame above.

3. Good returns on equity (ROE) while employing little or no debt

This criterion’s purpose is similar to the second: It helps Buffett identify companies with competitive advantages. Generally, a company that has a history of generating good ROE while employing little or no debt has a high chance of possessing durable competitive advantages.

Here’s a table illustrating Sinopec’s return on equity, and total-debt-to-equity ratio, from 2013 to 2017:Source: S&P Global Market Intelligence

The company ended 2017 with an ROE of 23% and negligible debt. Its cash balance, as at 31 December 2017, was RMB 9.5 billion, with RMB 0.61 billion in total debt. This points to a strong balance sheet.

4. Management in place

Buffett included this criterion because he did not want to have to provide a management team when he acquires a company. For stock market investors like you and me, this criterion has no real meaning, since public-listed companies almost always have leaders in place. However, this point is a reminder for us to take a look at the people running a company when researching a stock.

According to its website, Sinopec’s executive director, chairman and president, Wu Haijun joined the parent company, Shanghai Petrochemical Complex, in 1984. He has held various positions since then. With over 30 years of experience in the firm, Sinopec should be in good hands.

5. A simple business

I feel Sinopec is a complex business to understand. However, it is worth noting that Buffett had this rule in place to cater to his circle of competence. He is only interested in acquiring businesses that he understands. Going with this train of thought, what I think is a complicated business may be simple for you, and vice versa.

6. An offering price

This is another criterion in Buffett’s checklist that is not applicable for stock market investors, since stocks have quoted prices that are easily seen, unlike the private businesses that Buffett evaluates for acquisitions. This criterion, though, serves as a useful reminder that the price we pay for a stock is critical.

If we overpay for a stock (meaning we invest in a stock at an expensive valuation), the chances of our investment succeeding will be low. A famous quote from Buffett, “Price is what you pay, value is what you get,” rings true here.

Coming to Sinopec, the company last traded at a stock price of US$60.06 yesterday, giving it a trailing price-to-earnings ratio of 7 and a dividend yield of 7.7%.

A Foolish conclusion

The deep dive I did earlier on Sinopec, and the application of Buffett’s checklist should help investors make a better-informed investing decision on the company. Stay tuned for more on the rest of the companies from the 2018 best stocks list. For a repository of all the articles in this new series that uses Warren Buffett’s acquisition criteria to analyse the 30 best stocks, you can head here.

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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.

Editor's note: The pre-tax earnings under criterion 1 was stated wrongly initially. It has since been corrected.