Warren Buffett is considered by many as the best investor of our generation.
The Oracle of Omaha has an investing track record which stretches over 50 years.
Every year, he writes an annual letter to his shareholders.
Within these letters are nuggets of wisdom, which is useful advice for investors.
In particular, for his 1977 letter, Buffett outlined four simple criteria for companies that he would buy:
“We want the business to be (1) one that we can understand, (2)
with favorable long-term prospects, (3) operated by honest and
competent people, and (4) available at a very attractive price.”
First off, the company has to be a business that he can understand.
For instance, Buffett invests in consumer product companies such as Coca Cola (NYSE: KO) and Kraft Heinz (NASDAQ: KHC).
These are businesses that are easier to understand compared to, say, the latest biotech discovery.
Moving over to local stocks, some companies that are easy to understand include Kimly Ltd (SGX: 1D0), which operates a chain of coffee shops around the island, as well as Jumbo Group (SGX: 42R), a food and beverage operator that is famous for its signature chilli crabs.
Of course, you should not invest purely because a business is simple to understand.
It’s also prudent to go through the company’s financials and evaluate its prospects before pulling the trigger.
Good long-term prospects
The second criteria relates to long-term prospects of a company.
Buffett prefers to own companies that he can reliably predict will likely be around decades from now.
Think chewing gum or razor blades.
On the flip side, technology is a domain that experiences rapid change.
It may be tough to predict if a specific technology may be replaced or substituted by a better one.
Take compact discs (CDs) for example.
Datapulse Technology (SGX: BKW) used to be in the CD business until it sold it off in 2018 due to the declining popularity of this storage medium.
CDs were being rapidly replaced by a small device known as a “thumb drive” that’s manufactured by another local company, Trek 2000 International (SGX: 5AB).
If you were a shareholder of Datapulse as CDs were experiencing terminal decline, you should realise that the business had poor long-term prospects unless it shifted its business focus.
Honesty and competence
The next criteria is a little more subjective.
Buffett likes the company to be run by people who are both honest and competent.
As investors, we do not want to be constantly looking over the shoulder of the management team that runs the businesses that we own because we cannot trust them.
A good method to assess management’s candour is to review what they promise versus what they deliver.
If there is any reason to suspect that management may be less than upfront, perhaps it’s time to consider selling your shares.
An attractive valuation
The final criteria can be considered more personal.
Buffett would like to be able to purchase the company with the three attributes above at an attractive price.
He would be unfazed by stock price falls as it presents a better buying opportunity for him.
As an investor, you can learn from his discipline too.
If the valuation of a company you are eyeing is too lofty, you can either wait to buy it, or size your position smaller.
Valuation in this case refers to commonly-used metrics such as the price-earnings ratio or price to free cash flow ratio.
It’s also a timely reminder that buying an attractive business that is overvalued may still translate to mediocre or even negative returns over the long run.
Get Smart: Putting it all together
Buffett is constantly on the hunt for new opportunities.
During Berkshire Hathaway’s (NYSE: BRK.A) recent annual general meeting (AGM), the Oracle of Omaha said that there is between US$70 billion to US$80 billion which he would love to put to work, if he gets the chance.
There may be four separate criteria mentioned above, but for me, the rules support one another.
Buffett buys to hold for the long term.
If we intend to do the same, then we should have a firm understanding of what the business does.
We should also have confidence that the right people are leading the company.
The company should enjoy favourable long-term prospects that allow it to post consistent growth in revenue, profits and dividends.
If all the attributes above are satisfied, then you’ll need to ensure you do not pay too high a price for its shares.
Buffett’s four tips provide a great guide for you to select companies that are suitable for your investment portfolio.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.