We start with the premise we are only interested in owning good companies, but we believe you can turn a good company into a bad investment if you pay too much for it. We use a business-like evaluation of each company designed to identify what a company is worth as a business today.
To find good companies, we start with return on shareholder equity (ROE). Since World War II, the average return on corporate shareholder equity has been about 14%. And we like better-than-average companies, so we look for companies with ROE over 14%. In a climate of 2 1/2% inflation and 4-5% interest rates, we need to see a P/E less than or equal to the ROE to consider purchasing the company. By contrast, in a climate of 9% inflation and 12% interest rates (during the 1970s) we were screening for a P/E less than half the ROE. Our screening process involves looking at approximately 3,000 companies every quarter. This allows us to see changes over time and spot trends in industries and sectors. So, we are always looking for good companies, but the price we are willing to pay for those companies changes as inflation and interest rates change.
Once we have identified companies meeting our ROE and P/E criteria, we begin our fundamental analysis. We dig into their numbers to learn how they achieved that ROE, and whether it is sustainable. We look at growth, profits, financial strength, labor relations and management teams.
Growth is an important consideration, especially the relationship between growth and ROE. If ROE is higher than the growth rate, the company is probably generating free cash flow. Cash flow puts a company in control of its own destiny. Growth rates higher than the ROE are not sustainable without additional debt or equity financing. We prefer companies with ROE that can comfortably fund growth. We like to see revenue-driven growth and not just cost cutting or accounting sleights of hand. Revenue tells you if the public is buying the company’s product and should be near the level of earnings growth. Both earnings and revenues growth should exceed the industry medians.
Clean balance sheets are important but can be more or less critical depending on the business and the stage of the economic cycle we are in at the time. Use of debt can help boost ROE when the company is performing strongly, but it can hurt the company when business slows down and the company still has to meet their interest payments. We look for companies with percentage of liabilities to assets lower than industry medians, and then look for free cash flow.
Labor relations and management teams are harder to quantify. In the final analysis, the quality of the management team is all you have, but we don’t know a better way of measuring them than by how well they have done the job historically. The quality of the management teams usually becomes clear in the fundamental analysis that we perform.
Most of our investments are the result of the process we describe above: we identify an interesting company through our screening process and then dig into the details to better understand the company and the environment in which it operates. Occasionally we do the reverse: we identify an opportunity in the environment and then go looking for a company that can best take advantage of the situation. An example is our actions in mid-April of 2020 when the spot price of a barrel of crude oil was less than $0. All energy companies had simultaneously sold off, but the negative pricing on crude oil was the sign that caught our attention. We then looked at energy companies that met our criteria and could take advantage of a return to rational oil pricing and invested in them.
Finally, our approach has been the same for almost 50 years.
