26189827 - checklist paper and pen

Building an Investment Checklist

By John P. Reese — 

In this year’s letter to Berkshire Hathaway shareholders, Warren Buffett refers to the conglomerate’s “gradual shift from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses.” An article in the Wall Street Journal last month titled, “Warren Buffett’s Berkshire Moves Away from Stock Picking,” underscores the shift in the context of the conglomerate’s offer to purchase power-transmission firm Energy Future Holdings for $9 billion in cash.

But the two activities are really horns on the same goat, and together represent what Buffett later calls a “two-pronged approach” to capital allocation that gives his company a “real edge.” Even though Berkshire may be turning its focus a bit more to the purchase of operating businesses, Buffett points out, the gains earned on its stock and bond portfolio “has continued in the post-1998 period to grow and deliver us hefty capital gains, interest and dividends that have provided us major help in financing the purchase of businesses.”

This is part and parcel of Buffett’s fundamental investing philosophy, as he explained in a 2014 CNBC interview: “If you own your stocks as an investment—just like you’d own an apartment, house or a farm—look at them as a business,” Buffett advised. When you factor this notion into Berkshire’s shift, it all makes sense. Add to the mix that Berkshire’s balance sheet is cash heavy, and it only stands to reason that Buffett is focusing more on buying entire businesses than pieces of businesses in the form of equity shares.

 

 

It also stands to reason that the checklist Buffett applies to buying businesses is consistent with the one used for purchasing stocks. On page 30 of this year’s Berkshire Hathaway annual report, Buffet outlines six acquisition criteria:

  1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units). Buffett wrote in this year’s letter, “The larger the company, the greater will be our interest: We would like to make an acquisition in the $5- to $20 billion range.”
  2. Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations);
  3. Businesses earning good returns on equity while employing little or no debt;
  4. Management in place (we can’t supply it);
  5. Simple businesses (if there’s lots of technology, we won’t understand it);
  6. An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

The quantitative metrics in the above list are also used to evaluate evaluate stocks for purchase, as outlined in the book Buffettology. I used these same measures to create a Buffett-inspired stock screening model for Validea, which identified stocks that score highly based on each criterion:

  • Predictable and stable earnings-per-share and EPS growth: Gilead Sciences (GILD), Masimo (MASI), Banco Macro SA (BMA).
  • Ten-year average return-on-equity of at least 15% and debt that is less than 2x equity: NetEase (NTES), Biogen (BIIB), Tractor Supply Co.(TSCO).
  • Management’s use of retained earnings that reflects a return of at least 12%: all companies listed above.
  • Positive free cash flow: all companies listed above.

Of course, the “checklist” above and the model I’ve built using Buffett’s investment criteria will never fully capture all the reasons Buffett buys stock in a particular company, but they can offer investors a guide of sorts as to what to look for in a business and how those characteristics translate into the potential for solid long-term returns. Learning from great investors and capturing their methods in highly disciplined ways, via checklists and other methods, can add discipline to the investment process and keep emotions in check, which are two very important elements for success in the markets.

This article originally appeared in Forbes, see all of John’s articles on Forbes.com here.

Photo: Copyright: aleksanderdn / 123RF Stock Photo

John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”.