Saturday, February 14, 2009

The Warren Buffett Way: Part III

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

In the first part of this review, we looked at the key influences on Warren Buffett’s investing philosophy. Now, we will look at the 12 tenets of the Warren Buffett Way, starting with the business tenets.

First, what does Warren Buffett look for in a company? This is easy to determine, because Buffett advertises for these acquisition targets in his annual reports, explicitly defining the things he looks for:

  • Companies he understands
  • Consistent earnings history
  • Favourable long-term prospects
  • Good ROE
  • Little Debt
  • Operated by honest and competent people
  • Available at an attractive price
  • A business he would be willing to hold forever

The Twelve Tenets of The Warren Buffett Way:

Business Tenets
Is the business simple and understandable?
Buffett believes in investing in companies within your “circle of competence.” When you invest outside this circle, you risk not understanding the business. When you don’t understand the business, you can’t understand what drives its success and what threatens it with failure. You must be convinced that the business you are buying will perform well over time, and this is the only way to be convinced of this.

Does the business have a consistent operating history?
Buffett buys businesses for the long run. Because no one can predict the future, he uses historical performance as a reasonable proxy for the future. If the company has been able to weather storms in the past and perform consistently in different operating environments, then it will likely continue to do so in the future. Stay away from companies that have not been consistent in the past and are in the midst of changing strategic direction, as this removes your ability to be confident in the company’s future.

Does the business have favourable long-term prospects?
Favourable long-term prospects depend on the company’s long-term competitive advantage. Buffett calls this the “moat” which “franchise” businesses have. You are looking for companies with products or services that (1) are needed or highly desired, (2) have no close substitute and (3) are not regulated. You might also want to consider how the company stacks up to Porter’s Five Forces, which help determine its level of market power. The bigger the company’s moat, the more sustainable its franchise.

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