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Warren Buffett's 3 criteria for buying a stock

The Motley Fool logo The Motley Fool 2/26/2020 Sean Williams
© Reuters

Berkshire Hathaway CEO Warren Buffett is well known for his stock-picking prowess and his unwavering devotion to the buy-and-hold ethos. Following the publishing of the company's annual letter to shareholders this past weekend, we learned that, since 1964, Berkshire Hathaway's per-share market value has increased by 2,744,062%, which compares to a "meager" return for the S&P 500 of 19,784%, inclusive of dividends, over the same time span.

Having more than doubled up the S&P 500's compound annual gain over a more than five-decade stretch has earned the Oracle of Omaha quite the following, and has made his annual letter to shareholders a must-read for long-term investors.

Buffett just lifted the hood on his business-buying criteria

Berkshire's recently published shareholder letter was filled with numerous nuggets of wisdom, just like the decades of updates that have preceded it. Investors were privy to an update on Buffett's eventual succession plans, and they were treated to an explanation regarding the importance of retained earnings.

But the most surprising revelation made in the 2019 Berkshire Hathaway shareholder letter might just be the three criteria Buffett looks for when buying a business. While Buffett has always been very forthcoming with snippets of wisdom as to what he looks for before making an investment, he's never so succinctly laid out the criteria for investment before.

Let's take a closer look at the three factors one of the greatest investors wants to see in a business before buying it outright, or making a non-controlling investment.

1. They must earn good returns on the net tangible capital required in their operations

If there was one message Buffett really wanted to convey in this year's shareholder letter, it was the importance of retained earnings. Retaining operating income and putting that capital back to work often proves far more valuable in the long run, in terms of hitting growth objectives, than paying a dividend to shareholders or repurchasing a company's own stock.

When Buffett is examining businesses within his wheelhouse to acquire or take an investment stake in, he's looking for businesses that generate significant returns on their equity. In fact, Buffett notes in the "Investments" section of Berkshire's shareholder letter that, on a weighted-basis, the company's 15-largest non-controlling holdings (which excludes Kraft Heinz) are earning more than 20% on the net tangible equity capital required to run their businesses.

Even though the Oracle of Omaha has admitted that one of his investment lieutenants purchased the 537,300 shares of Amazon Berkshire owns, Amazon perfectly fits the bill of what Buffett is looking for in a business. Amazon's operating margins aren't much to speak of, in part because of the large percentage of revenue derived from its low-margin retail operations. However, its trailing-12-month return on equity is almost 22%, which is a function of aggressively reinvesting in fast-growing, high-margin cloud services (Amazon Web Services) and seeing those investments pay off in the form of higher operating cash flow and income.

2. They must be run by able and honest managers

While this should be a common-sense factor all investors look for, Buffett places especially strong emphasis on the ethics of the management team and board behind each business he's evaluating.

As you might recall, Buffett has spoken candidly about trust and reputation in previous shareholder letters. Two of the more standout Buffett quotes on the subject are as follows:

  • "It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently." 
  • "Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless."

What's particularly notable about Buffett's unwillingness to compromise when it comes to trust in management and a company's reputation is that it perfectly describes why he's probably been selling down his mammoth stake in banking giant Wells Fargo. Wells Fargo seriously breached the trust of its consumer in 2016 when it was revealed that 3.5 million unauthorized accounts were created. These accounts were part of an aggressive cross-selling strategy used in Wells Fargo's physical branches.

With Wells Fargo having excused two CEOs since this scandal was revealed, Buffett might be realizing that real damage has been done to this money-center banks' reputation for the foreseeable future. This would certainly explain why Buffett's company has sold approximately 156 million shares of its stake in Wells Fargo (in total) in recent years.

3. They must be available at a sensible price

Even though Buffett is a firm believer in stocks outperforming all other asset classes over the long term, he's still quite the stickler when it comes to valuation.

In last year's shareholder letter, Buffett noted, "Prices are sky-high for businesses possessing decent long-term prospects," which explains why his company's cash hoard remains near an all-time high at $128 billion. It also allows investors to understand why he's been a net seller of equities in recent quarters.

But defining what "a sensible price" means for Buffett isn't as easy as deciphering a company's returns on net tangible capital. It can be completely arbitrary from one investor to the next.

One of the few examples at the moment that demonstrates Buffett's affinity for "a sensible price" is the Oracle of Omaha's purchase of 2.73 million shares of General Motors during the fourth quarter. There's no questioning that the auto industry is working through a rough patch. Chinese auto sales are way down, and automakers like General Motors are laying off workers and closing plants to reduce costs. GM was also dealt a particularly difficult hand recently as it contended with the United Auto Workers' strike.

However, General Motors is also valued at a little below six times this year's consensus profit forecast from Wall Street. Even with the auto industry historically trading for a much lower earnings multiple than practically every other industry, this is still inexpensive, even for GM. Known for taking advantage of investor fear, Buffett probably saw this as an opportunity to tack onto his company's existing position in General Motors.

And that, my fellow investors, are the three criteria the greatest investor of our generation is looking for when buying a stock.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon and Berkshire Hathaway (B shares) and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short March 2020 $225 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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