Picking good companies to invest – the Warren Buffett way

Published in The Hindu - Sunday Magazine on Mar 29, 2009

Stock picking for above-average long-term returns begins with identifying good companies to invest in.

Many aspiring investors think that buying stocks blindly based on ‘recommendations’ from others who claim to be ‘experts’ either on a newspaper, magazine, T.V or brokerage report, is ‘stock picking’. If you have still not learnt a lesson despite having lost significant amount of money already by following this technique, then reading ahead is probably too much effort that is not worth it anyway. I guess some things never change, as the 18th century philosopher Georg Wilhelm Friedrich Hegel once said - “We learn from history that we do not learn from history”.

For the others that want to really learn how to choose stocks on their own and are willing to do a little homework before plunking down hard earned money, who could be a better teacher than Warren Buffett? - The most successful investor in the world with a 40-year track record of picking stocks (and buying companies) that have generated average returns of 20% p.a (this definitely questions the credibility of the lofty claims that some of our own ‘experts’ make about generating 50%-100% returns p.a.). His approach to investing is one of the few out there, that can be termed as ‘simple’ (not to say that it is ‘simplistic’ by any means, else everyone who follows him would have become billionaires!). But, there are many who started with a few thousands worth of Berkshire Hathaway (the company run by Warren Buffett) shares that are now worth many millions. Wouldn’t it be great if you too could learn his approach and apply it to investing on your own? Actually, as utopian as the goal may seem, all the tools required for practicing investing like Warren Buffett are readily available and supplied by Buffett himself. Yes! I am talking about the letters written by Warren Buffett to his company’s shareholders every year dating back to the 1970’s. They can all be downloaded free of charge from www.berkshirehathaway.com. (psst! I happen to have some of the earlier letters that are not posted on the website, incase anyone of you is interested). These letters lay out pretty much everything that an investor needs to know including what mistakes to avoid - by learning from Buffett’s own mistakes, which have been thoroughly analyzed by none other than himself.

Buffett Philosophy

Buffett’s investment philosophy is based on ‘Buying good companies at bargain prices’. Let’s take the first part – ‘buying good companies’. How do you identify a good company? Is it the one with the highest sales growth? Highest profit growth? Highest profit margin (i.e.profit per rupee of sales)? Largest market share? The list can practically go on and on given the number of financial ratios available. But, what is ‘the’ most important parameter that helps gauge how good a business is? Before I introduce what I like to call ‘the God ratio’, let me ask you a question. What do you ask for before you put your money in a fixed deposit? It is probably “What is the interest rate offered?” i.e. “What is the return that you are going to get?” right? Well, businesses can also be benchmarked in a similar manner based on the returns they generate.

Assume you have inherited Rs1 crore, you have an opportunity to either start a business using the capital or invest the amount in a fixed deposit. You have two business ideas - one is a restaurant and other is an ice-cream parlour. After detailed research, here are your findings. The restaurant business is expected to generate Rs. 10 lks profit per annum. The ice cream parlour on the other hand is expected to generate a profit of Rs 15 lks per annum for the same investment amount of Rs 1 crore. The third option is to invest your money in a fixed deposit that will pay you an interest of 9% p.a. Which option would you pick? Obviously the ice-cream parlour, right? Why? Because it offers the highest return-on-capital i.e. 15 lks / 1 crore (15%). This is higher than the 10% offered by the restaurant business and also higher than the 9% that you would get from the FD option. According to Buffett, it is this ratio – the ‘return-on-capital’ (‘the God ratio’) that sets apart a good business from a poor one.

Fast forward into the future: your ice cream parlour is in its fifth year of operation but unfortunately you have never been able to generate more than Rs 10 lks per annum profit (i.e. 10% return-on-capital). You have tried everything you could but you just can’t seem to get the business to produce a higher return-on-capital. You look up the fixed deposit rates – they remain at 9%. What would you do? If you were a rational businessman, you would rather sell the enterprise, park you money in FD & relax, while still earning almost the same profit!

To summarise, it doesn’t pay to be in business, if the business can’t earn in terms of return-on-capital, a rate that is higher than what you could otherwise earn by just parking your funds and receiving interest at almost zero risk. So you may ask, what is the ideal return-on-capital for a business? 15%? 20%? or 30%?

Actually, I don’t know! It depends on your level of risk aversion. After all, businesses carry a higher risk than FD. So it is fair to expect a higher return. My opinion is, the return-on-capital from a good business needs to be greater than 20% p.a.

What’s so special about high return-on-capital companies?

Not many listed companies in our country have a track record of earning more than 20% return-on-capital. But still they continue expanding, by hiring more people, opening more branches, spreading abroad, acquiring companies larger than themselves using debt and just growing mindlessly, sometimes even faster than their competitors that earn higher returns on capital. How are they able to do this? The answer is…by raising more and money from the public or from other investors who are too enamoured with the ‘growth story’. But is such a growth that depends mainly on raising more capital but produces low returns on the capital, sustainable? Probably not. Even if it does, it is never going to produce above-average long-term returns to the shareholders. Because, over the long term, return on your investment in a company’s shares depends on the return-on-capital that the company generates for itself.

Companies that ‘consistently’ achieve a high return-on-capital can be considered to be ‘fitter’, as they are likely to have long-term advantages of some kind. This advantage protects them from competition and helps them continue to earn above-average profit by using relatively less capital. If you are a long-term investor who wants to buy and hold stocks, it is these companies that you want to own shares of. Having said that, you need to note that there is a gap between a good company and a good investment – it is called ‘price’ i.e the price at which you buy the shares of the company. In my forthcoming articles, I will discuss simple techniques to compute the return-on-capital for a company and to arrive at a bargain price for acquiring shares of companies that have a track record of ‘consistently’ generating high return-on-capital. This combination of buying above-average companies at below average prices will help you to reap above-average return on your investment for many years to come.