Unravelling Warren Buffett's Investment Criteria

Three essential items for every investment

Dear Investors,

Warren Buffett packs a punch in his letters to shareholders.

In his 2019 letter, he revealed his criteria for buying new businesses.

This week, we unravel these very insightful words.

Sincerely, Raj

In Berkshire Hathaway’s 2019 letter to shareholders, Buffett said:

“We constantly seek to buy new businesses that meet three criteria.

  • First, they must earn good returns on the net tangible capital required in their operation.

  • Second, they must be run by able and honest managers.

  • Finally, they must be available at a sensible price.”

Guy who looks Buffett-ish

Good returns on net tangible capital

For starters, what is net tangible capital? Capital refers to the total assets used in the business. Net means assets net of liabilities. Tangible means excluding goodwill and intangible assets. Putting all that together Buffett is looking at the return on tangible equity (ROTE).

The problem with equity

Most businesses are funded using a combination of debt and equity. If a business has $60 in debt and $40 in equity funding, then its total assets will equal $100.

The easiest way to increase the return on equity, without improving the business, is to change the funding mix. If you increase the debt to $70 and reduce the equity to $30, you still have $100 in assets. The business is no better off. However, the return on equity will be higher because you have reduced the amount of equity. That’s the problem with using return on tangible equity -  debt can skew the results.

At ROA, we look at return on capital employed and return on assets. These measures include both debt and equity, so you cannot skew them.

BUT…

Berkshire Hathaway is a financial company. The core operations are in insurance and Berkshire owns shares in a number of other financial companies, such as banks. 

Measures like return on capital employed and return on assets don’t make sense when analysing financial companies.

Let’s take a bank as an example. A bank borrows money from its depositors (savings accounts) and then lends it out to borrowers (car, home, business loans, etc). The bank makes a small profit on the difference between interest that it charges and interest that it pays. So a bank makes a small profit on a large amount of assets. As a result, the return on assets looks tiny. Therefore, it doesn’t make sense to use return on assets or return on capital employed to measure the performance of most financial companies.

However, return on equity does make sense because it ignores all that leverage (borrowed money) and looks at the return on the equity in the business.

The problem with tangible assets

An intangible asset such as goodwill will not be on the balance sheet unless the company has acquired another company. Financial companies usually don’t have many other intangible assets like patents. So Buffett’s requirement to use tangible equity makes sense when investing in financial companies because it only looks at the return on the productive assets.

But it doesn’t make sense if you look at other modern companies like technology and pharmaceutical companies. These companies create intellectual property (intangible assets) and earn returns on these assets. For these types of companies it makes sense to include the intangible assets in your return measures. It also makes sense to look at return on total assets or return on capital employed, so you don’t get fooled by the use of debt. 

Able and honest managers

In Berkshire Hathaway’s 1983 letter to shareholders, Buffett said “We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.

There are two benefits to having honest managers. Firstly, as an owner, you want to know the good and the bad things that are happening in a business. An honest manager keeps you fully apprised and this builds trust.

Secondly, honesty with oneself is important in business and investing. Every now and then one is going to make a mistake or do something that doesn’t work. If one is honest with yourself, you can identify the mistake and correct it. If you fool yourself, you don’t learn from mistakes. 

Available at a sensible price

Notice that Buffett said “a sensible price”, he did not say a cheap price.

In Berkshire Hathaway’s 1989 letter to shareholders, Buffett said “it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” 

In the financial world, value and growth are thought of as opposites, but they are really two parts of the same equation. 

A company can appear expensive, but if it has a strong growth opportunities, then it can actually be valued cheaply at that price. 

Nvidia is a good example of that. On historical numbers it looks very expensive, it has a historical price-to-earnings (P/E) ratio of 58. But if one looks at the forecasted P/E ratios, it looks much cheaper:

  • 2025: P/E = 44.0

  • 2026: P/E = 31.2

  • 2027: P/E = 26.4

  • 2028: P/E = 24.5

  • 2029: P/E = 24.0

Conclusion

In the investing world, Buffett’s letters are the stuff of legends. They are worth reading and re-reading. Buffett regularly packs huge amounts of wisdom and experience into a few sentences. Every time you read them, you unravel more and more.

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