By John P. Reese
When Warren Buffett was a kid, he liked to read. More than most kids. And we’re not talking comic books and bubble gum wrappers, either. He once recalled receiving the World Almanac as a gift when he was a young boy. “It was like heaven to me,” he says.
Is it a coincidence that this voracious reader became one of the most successful investors of all time? Maybe not. When asked about the key to his success, Buffett puts reading at the top of the list. “That’s how knowledge works,” he said, “It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.”
You might expect Buffett to enlist his fervor for reading when evaluating a company to acquire—to scour through every document he can get his hands on and read as much detail as possible. But that’s not his modus operandi–in fact, Buffett is known for his remarkably streamlined approach to due diligence. A few years ago, when asked about Berkshire’s $37 billion deal to purchase airplane parts manufacturer Precision Castparts, Buffett said he met with the company’s CEO Mark Donegan for about 25 minutes in total before arriving at an agreement. “We basically do no due diligence,” Buffett quipped. “Our due diligence is basically looking into their eyes.”
But how do these approaches reconcile? How does an investor agree to pay billions of dollars for a company based on a half-hour meeting with management? During a Q&A at this year’s annual meeting of Berkshire shareholders, Buffett explained his seemingly unorthodox process: “Spotting bad apples doesn’t come from looking at documents,” he quipped, adding, “We make plenty of mistakes in acquisitions, but the mistakes are always about making an improper assessment of the future economic conditions of the industry or company. It’s never about a bad lease, labor contract, or a questionable patent.”
The takeaway for investors is that, even on the scale of billion-dollar acquisitions, more information is not necessarily better. “What counts,” says Buffett, “is if you have a fix on the basic economics and how the industry’s likely to develop or whether Amazon is going to kill them in a few years.”
Not many investors, if any, are wired like Warren Buffett or spend most of their day reading about the markets (not minute-by-minute market movements) and individual companies with his level of dedication. But that doesn’t mean the average Jane or Joe can’t apply this approach on a smaller scale. Remember, Buffett generally evaluates companies against a checklist of both quantitative and qualitative fundamentals to see if they pass muster before he considers them for investment or acquisition. Using readily available information, he looks for the following quantitative characteristics,. as I’ve captured them on Validea and as was outlined in the book, Buffettology:
- Predictable and stable earnings-per-share and EPS growth;
- Debt that is less than 2x equity;
- Ten-year average return-on-equity of at least 15%;
- Positive free cash flow
- Management’s use of retained earnings that reflects a return of at least 12%
On the qualitative side, Buffett favors companies that have solid, reliable businesses involving simple products or services and that enjoy durable competitive advantage that is nearly impenetrable. This means that a company has some quality that makes it almost impossible for a competitor to overtake it, regardless of how much money that competitor is willing to spend. He looks for household names and businesses that are easy to understand.
Since Buffett doesn’t use a computer, he is insulated from the endless barrage of news item pop-ups and ticker tape feeds that can entice investors hungry for hunches and the “next big thing.” He culls through a vast amount of data and keeps up to date on industries and sectors within those industries. One of his favorite weekly indicators, for example, is railcar traffic–because it is linked to changes in quarterly GDP. In fact, he once said that if he were stuck on a desert island and allowed only one economic indicator, that would be it. Buffett also popularized the ratio of total market capitalization to GDP as a tool to gauge valuation levels. He uses such information to stay on top of market conditions and to help him evaluate long-term investment opportunities.
Whether you have eight hours or thirty minutes a day, it’s important to discern between useful and superfluous market information when making investment decisions. In this realm, more is not necessarily better—unless, of course, you’re talking about returns.
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”.