The New Buffettology: 10 Important Things Buffett Looks for In a Company

by | Aug 26, 2020

In The New Buffettology (2002) Mary Buffett and David Clarke list 10 Important Things Buffett Looks for In a Company.

Buffett’s goal is to invest in companies with a Durable Competitive Advantage.

According to The New Buffettology, a company with a durable competitive advantage usually sells a brand name product or service that holds a privileged position in the industry that allows it to price its product as if it faces little or no competition, creating a kind of monopoly.

If the company has these 10 characteristics then it implies that the company has a Durable Competitive Advantage. 

  1. A Consistently High Return on Shareholder Equity.
  2. A Consistently High Return on Total Capital.
  3. A Consistently High Earnings per Share (EPS).
  4. Modest Amounts of Debt. 
  5. A Product or Service With a Durable Competitive Advantage.
  6. In an Industry Lacking Organized Labor.
  7. A Product that can be Priced to Keep up With Inflation.
  8. A High Return on Retained Earnings.
  9. The Company can Buy Back Shares to the Investors Advantage.
  10. The Retained Earnings Increase the Market Value.

1. A Consistently High Return on Shareholder Equity 

Shareholder equity, usually just called equity, is the part of the business which the shareholders own. Shareholder equity equals total assets minus total liabilities

Shareholder Equity = Total Assets – Total Liabilities

Let’s say you purchase a home for $300,000. To purchase the home you spend $100,000 of your own money and borrow $200,000 from the bank. 

In this case, the total assets would be $300,000 and the total liabilities would be $200,000. This means the equity would be $100,000. 

$300,000 – $200,000 = $100,000

In 2019 Apple had total assets of approximately $338 billion and total liabilities of approximately 248 billion this means they had shareholder equity of approximately $90 billion. 

$338 – $248 = $90

We want to know the return the company generates from the shareholder equity. To find this we divide net income by the shareholder equity. 

Return on Shareholder Equity = Net Income / Shareholder Equity

For example, you rent the house out and profit $15,000 per year. Your net income equals $15,000. Your return on equity would be 15%.

$15,000 / $100,000 = 0.15 = 15%

In 2019 Apple had a net income of $58 and shareholder equity of 90 billion. This means they had a return on equity of 64.4%.

$58 / $90 = 0.644 = 64.4%

According to The New Buffettology, the average return on shareholder equity for US companies over the past 50 years has been around 12%. 

A high return on shareholder equity would be one that is greater than average. 

We don’t want just one year of  high return on shareholder equity. We want consistent and stable or even growing return on shareholder equity over the past 10 years. Such as that of Apple shown in the chart below.

Data sourced from morningstar.com

2. A Consistently High Return on Total Capital

The problem with return on shareholder equity is that companies can purposely shrink their equity by paying large dividends taking on debt or repurchasing shares. 

According to The New Buffettology, companies will do this to make their return on shareholder equity greater thus making the stock more enticing to investors

To solve that problem Buffett looks at Return on Total Capital. 

Total Capital equals Shareholder Equity plus total debt.  

Total Capital = Shareholder Equity + Total Debt

In our House example, the Total Capital would be $300,000. 

$100,000 + $200,000 = $300,000

Return on Total Capital also called Return on Invested Capital equals net income divided by total capital.

Return on Total Capital = Net Income / Total Capital

For our house with $15,000 in net income, the return on total capital would be 5%.

$15,000 / $300,000 = 0.05 = 5%

According to The New Buffettology, Buffett has historically gone for companies with a return on total capital of 20% or higher

3. Consistently High Earnings per Share (EPS)

Companies with a durable competitive advantage will produce consistently high earnings per share. 

Earnings per share equals net income divided by the number of shares outstanding.

Earnings per Share = Net Income / Shares Outstanding

We want to see a strong and upward trend in earnings over time, such as that of Apple shown in the chart below.

Data sourced from morningstar.com

4. Modest Amounts of Debt 

A company with a durable competitive advantage will be relatively free of long term debt. Long term debt isn’t expected to be paid off within the next 12 months.

With high amounts of debt come high interest repayments. Large amounts of long term debt can be concerning because it restricts a company’s ability to survive a recession. During recessions, earnings decrease and can be life-threatening for a business that needs to pay off high amounts of interest. 

If you had your salary cut in half how easily would you be able to pay the mortgage on your home? If you can’t pay your mortgage the bank will repossess your home. If a company can’t pay off its debt it may be forced to liquidate

The best way to analyze debt is by its ability to pay off its debt using its earnings. A company should have long term debt less than 5 times its yearly net income. There are some exceptions to this rule such as financial companies including banks that rely on having large amounts of long term debt to make their money. 

Long Term Debt < 5 x Net Income

5. A Product or Service With a Durable Competitive Advantage

Warren Buffett invests in businesses that sell a product with a durable competitive advantage. To determine if a company has a durable competitive advantage you should ask yourself these questions.

  • Does the company sell a brand name product or service?
  • What about a key product or service that customers are dependent on?
  • Do stores need to stock that product in order to stay in business?
  • Would the businesses be losing sales if they didn’t stock the product?

To answer these questions you need to understand the product. If you don’t understand the product, search it on the internet. You should be able to find an article or a book about the product or company. 

Follow that up by finding out where they sell the product.  Ask a sales clerk if it is one of the top two products they sell. We don’t want to invest in the third or fourth most popular products. 

We want brand name products that have been on the market for years. The types of products we are looking for are the ones your parents used when you were growing up and are still on the market today. 

6. In an Industry Lacking Organized Labor 

Organized labor can hurt your investment. If labor can organize into unions they can demand higher wages or cripple the business with strikes. The company is forced to pay up or hemorrhage money due to unproductivity. In the long term, the company will constantly battle to maintain its profit margins. 

Garment Workers on Strike, New York City, USA, Circa 1913. https://www.flickr.com

7. A Product that can be Priced to Keep up With Inflation

Inflation makes prices rise. As prices rise the cost of production increases. If the company can’t raise the price they sell their product for then their profit margins will be eaten away.

The airline industry is an example of an industry that can’t keep up with inflation. According to The New Buffettology, a flight from Omaha to Paris cost around $1,000 or more in the 1960s. As of 2002, you could get one for around $400 dollars. The cost of wages, airplanes, and fuel has all gone up over that time but the price of flights has gone down. 

A business with a durable competitive advantage can raise its prices along with inflation without experiencing a decline in demand. In fact, a business that can increase prices along with inflation will actually see an increase in earnings. A business with a durable competitive advantage is essentially inflation proof. 

8. A High Return on Retained Earnings

When a company generates earnings it has two options. 

  1. They can pay out the earnings to shareholders through a dividend.
  2. They can retain their earnings. 

Retained earnings can be spent in many different ways such as:

  • To expand their operations such as opening new stores or factories.
  • Developing new products.
  • Funding a merger or acquisition.
  • Buyback shares.
  • Pay off debt
  • Maintain and replace the current plant, property, and equipment. (Maintenance Capital Expenditure)

Companies with a competitive advantage usually don’t have to spend a high percentage of their retained earnings to maintain their operations.

According to The New Buffettology, Warren’s perfect business would be one that spends $0 on maintaining its competitive advantage. The business would be free to use every dollar of retained earnings to either pay a dividend or grow, making shareholders wealthier. 

We can see how efficiently management utilizes retained earnings by measuring its effect on earnings. We can call this the Return on Retained Earnings. Return on Retained Earnings equals retained earnings over a period of time divided by the change in Earnings per Share over a period of time 

How to Calculate Return on Retained Earnings 

Step 1: Add up all the Earnings per Share (EPS) for the time period.

Step 2: Add up all the dividends for the time period. 

Step 3: Subtract the total dividends from the total EPS. This will give you the total retained earnings per share for that time period. 

Step 4: Subtract the EPS in the first year from the EPS in the most recent year. This will give us the change in EPS.

Step 5: Divide the change in EPS by the total retained earnings equals Return on Retained Earnings. 

Let’s calculate the return on retained earnings for Apple for the past 10 years (2010-2019).

Step 1: Add up all the Earnings per Share (EPS) for the past 10 year.

Year2010201120122013201420152016201720182019
EPS2.163.956.315.686.459.228.319.2111.9111.89
Total75.09
Apple’s 10 year EPS history. Data from morningstar.com

Over the past 10 years Apple generated a total of $75.09 in earnings per share.

Step 2: Add up all the Dividends for the past 10 years. 

Year2010201120122013201420152016201720182019
Dividends000.381.631.811.982.182.42.723
Total16.10
Apple’s 10 year Dividend History. Data from morningstar.com

Over the past 10 year Apple paid out a total of $16.10 per share in Dividends. 

Step 3: Subtract the total dividends from the total EPS. This will give you the total retained earnings for that time period. 

Total Retained Earnings = Total EPS – Total Dividends

$75.09 – $16.10 = $58.99

Over the past 10 years Apple retained a total of $58.99 per share. 

Step 4: Subtract the EPS in the first year from the EPS in the most recent year. This will give us the change in EPS.

Change in EPS = Most recent EPS – First EPS

$11.89 – $2.16 = $9.37

Over the past 10 years EPS grew by $9.37.

Step 5: Divide the change in EPS by the total retained earnings equals Return on Retained Earnings.

Return on Retained Earnings = Change in EPS / Total Retained Earnings

$9.37 / $59.99 = 0.156 = 15.6%

Over the past 10 years Apple produced a 15.6% return on retained earnings on average per year. 

Unfortunately The New Buffettology doesn’t give us a benchmark for a “high” return on retained earnings. Perhaps we should use the historical average yearly return on the stock market of around 10%. If we use 10% then Apple’s return on retained earnings is certainly high. 

9. The Company can Buy Back Shares to the Investors Advantage

A share buyback is when the company will buy back shares from shareholders. This leaves shareholders who didn’t sell a larger piece of the company. Owning a larger share of the company means you are entitled to a larger share of the profits.

In order for a company to consistently buy back shares, they must be able to generate an abundance of cash. The ability to generate an abundance of cash indicates a durable competitive advantage.

In the chart below we can see the 10-year history of shares outstanding for Apple. As you can see the number of shares outstanding has consistently decreased. Apple shareholders who didn’t sell back to the company have grown their share of the company and the profits without buying a single extra share. 

Apple’s 10 year shares outstanding history. Data from morningstar.com

10. The Retained Earnings Increase the Market Value

According to The New Buffettology, if you can purchase a company with a durable competitive advantage at the right price the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company’s stock. 

What we want to see is that for every dollar retained at least one dollar of market value is created.

To find whether at least one dollar of market value is being created from each dollar retained we need the total retained earnings for a period of time and the change in market value for that same period. 

Unfortunately, The New Buffettology doesn’t tell us exactly when or what price we should use. Stock prices change every day so it is hard to determine how much market value is created over time. 

Our goal is to buy these businesses when their stock price is suffering. So I think it makes sense to imagine we are buying the stock at its lowest point in the first year and then measure the market value change at its lowest point in the most recent year. 

Calculating Market Value Return to Retained Earnings 

Step 1: Add up all the Earnings per Share (EPS) for the time period.

Step 2: Add up all the dividends for the time period. 

Step 3: Subtract the total dividends from the total EPS. This will give you the total retained earnings per share for that time period. 

Step 4: Find the market low from the first year and subtract that from the market low of the most recent year. This will give us the change in market value. 

Step 5: Divide the change in market value by the total retained earnings. This gives us the market value return to retained earnings.  

Let’s calculate the market value return to retained earnings for Apple for the past 10 years. 

We already did the first 3 steps in Characteristic 8: A High Return on Retained Earnings.

Step 1: Add up all the Earnings per Share (EPS) for the time period.

Over the past 10 years Apple generated a total of $75.09 in earnings per share

Step 2: Add up all the dividends for the time period.

Over the past 10 year Apple paid out a total of $16.10 per share in Dividends. 

Step 3: Subtract the total dividends from the total EPS. This will give you the total retained earnings per share for that time period. 

Over the past 10 years Apple retained a total of $58.99 per share. 

Step 4: Find the market low from the first year and subtract that from the market low of the most recent year. This will give us the change in market value. 

According to macrotrends.com In 2010 Apple recorded a price low of $27.43. In 2019 Apple recorded a price low of 142.19.

Change in Market Value = Market Price most recent year – Market price first year

$142.19 – $27.43 = $114.76

Step 5: Divide the change in market value by the total retained earnings. To find the total market value return on retained earnings. 

Market Value Return on Retained Earnings = Change in Market Value / Total Retained Earnings

114.76 / 58.99 = 1.94

We want to see that $1 of retained earnings produces at least $1 in market value.

For every dollar Apple retained for the past 10 years they generated $1.94 in market value. 

Summary

In The New Buffettology (2002) Mary Buffett and David Clarke explain 10 screening criteria that need to be met for Warren Buffett to invest in a company.

  1. A Consistently High Return on Shareholder Equity
  2. A Consistently High Return on Total Capital
  3. A Consistently High Earnings per Share (EPS)
  4. Modest Amounts of Debt 
  5. A Product or Service With a Durable Competitive Advantage
  6. In an Industry Lacking Organized Labour
  7. The Product can be Priced to Keep up With Inflation
  8. A High Return on Retained Earnings
  9. The Company can Buy Back Shares to the Investors Advantage
  10. The Retained Earnings Increase the Market Value

If you want to learn more about Warren Buffett and his investment strategy I recommend you pick up a copy of The New Buffettology by Mary Buffett and David Clarke. The book also discusses the best time to buy stocks, how having a long term investment strategy can help you outperform, the best time to sell stocks, and Special Investment Situations. 

Get your own copy of The New Buffettology. (This is NOT an affiliate link.)

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