Before I start writing about the annual reports I read I want to let you guys know about my personal biases (because you might not share them) and about what kind of companies I look for…
To put it simply, my personal biases are:
- I hate debt;
- I like dividends;
- I love discounts.
I hate debt because it’s the main reason companies go bankrupt. I am well aware that, if used conservatively and efficiently, debt can be used to increase returns on equity, but if the company runs into trouble (even if it is temporary) and is unable to meet its loan payments it will go bankrupt, the creditors will claim the assets, and the shareholders will be lucky if they retain a small sliver of their investment. If a company has no loans, I’m much more confident that it will be able to survive any bad periods it may have, and that I will not suffer a permanent capital loss.
I like dividends because, even if you find a company you think is undervalued, it may take years for the market to fully recognise its value. If I am to wait patiently for this to happen, I want to at least have the satisfaction of seeing some money coming into my account. Having said that, I would not insist upon this if I’m fairly confident that management is using the retained earnings rationally and getting a good rate of return on capital.
I love discounts (aka margin of safety) because you make your money when you buy, not when you sell. Most people buy shares in the expectation that their price will rise, without having any clue as to how much they are really worth. Safe to say this sometimes doesn’t work out so well. I feel it’s much better to do the opposite. Know the value, and buy it for much less (money in the bank, basically). Don’t you like going to the supermarket and seeing a promotion to buy 2 for 1 (a 50% discount!) of one of your favorite items?
So, what kind of companies do I want to invest in? In Berkshire Hathaway’s Shareholder Letters and annual reports, Warren Buffett has mentioned several acquisition criteria throughout the years. I think the most important ones are:
- Demonstrated consistent earning power with favorable long-term prospects;
- Good returns on equity with little or no debt;
- Honest management that makes rational capital allocation decisions;
- Simple business selling for a significant discount to its value.
Easier said than done! The great majority of public companies do not fulfill these criteria. Many of them are cyclical (meaning they do well in good economic times but struggle when the tide turns), or complex (you couldn’t figure them out even if you had years to do it), or are selling for an expensive price, or have poor returns because their managers just keep plowing money into bad investments or buying companies for more than they are worth just to make their company bigger (when they should just return that money to shareholders).
Hence, I do not expect to make new investments every week, or every month for that matter. If I can find a good investment or two per year, I will be happy. One of my favorite Buffett quotes is:
“An investor should act as though he had a lifetime decision card with just twenty punches on it.”
Instead of buying shares like you’re buying candy or a six-pack (like most retail traders), buy shares with the same care as you would when buying a house.