Consumer monopoly or commodity?
Buffett seeks out consumer monopolies selling products in which there is no effective
competitor, either due to a patent or brand name or similar intangible that makes the
product unique. Investors can seek these companies by identifying the manufacturers of
products that seem indispensable. Consumer monopolies typically have high profit margins
because of their unique niche; however, simple screens for high margins may simply
highlight firms within industries with traditionally high margins. AAII's Stock Investor
Professional is used to perform the screen. For our screen, we look for companies with
operating margins and net profit margins above their industry norms. The operating margin
concerns itself with the costs directly associated with production of the goods and
services, while the net margin takes all of the company activities and actions into
account. Additional screens for strong earnings and high return on equity will also help
to identify consumer monopolies. Follow-up examinations should include a detailed study of
the firm's position in the industry and how it might change over time.
Do you understand how it works?
As is common with successful investors, Buffett only invests in companies he can
understand. Individuals should try to invest in areas where they possess some specialized
knowledge and can more effectively judge a company, its industry, and its competitive
environment. While it is difficult to construct a quantitative filter, an investor should
be able to identify areas of interest. An investor should only consider analyzing those
firms passing the Buffett screen operating in areas that they can clearly grasp.
Is the company conservatively financed?
Consumer monopolies tend to have strong cash flows, with little need for long-term debt.
Buffett does not object to the use of debt for a good purpose-for example, if a company
uses debt to finance the purchase of another consumer monopoly. However, he does object if
the added debt is used in a way that will produce mediocre results-such as expanding into
a commodity line of business.
We screen for companies with conservative financing by seeking out companies with total liabilities to assets below the median for their respective industry. Appropriate levels of debt vary from industry to industry, so it is best to construct a relative filter against industry norms. The ratio of total liabilities to total assets is more encompassing than just looking at ratios based upon long-term debt such as the debt-equity ratio.
Are earnings strong and do they show an upward trend?
Buffett invests only in a business whose future earnings are predictable to a high degree
of certainty. Companies with predictable earnings have good business economics and produce
cash that can be reinvested or paid out to shareholders. Earnings levels are critical in
valuation. As earnings increase, the stock price will eventually reflect this growth.
Buffett looks for strong long-term growth as well as an indication of an upward trend. In the book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Professional contains only seven years of data, so we examine the seven-year growth rate as the long-term growth rate and the three-year growth rate for the intermediate-term growth rate.
For our screen, we first require that a company's seven-year earnings growth rate be higher than that of 75% of the stocks in the overall database. Stock Investor Professional includes percentile ranks for growth rates, so we specify a percentile rank greater than 75.
It is best if the earnings also show an upward trend. Buffett compares the intermediate-term growth rate to the long-term growth rate and looks for an expanding level. For our next filter, we require that the three-year growth rate in earnings be greater than the seven-year growth rate.
Consumer monopolies should show both strong and consistent earnings. Wild swings in earnings are characteristic of commodity businesses. An examination of year-by-year earnings should be performed as part of the valuation. A screen requiring an increase in earnings for each of the last seven years would be too stringent and not be in keeping with the Buffett philosophy. However, a filter requiring positive earnings for each of the last seven years should help to eliminate some of the commodity-based businesses with wild earnings swings.
Does the company stick with what it knows?
Companies that stray too far from their base of operation often end up in trouble. Peter
Lynch also avoided profitable companies diversifying into other areas. Lynch termed these
"diworseifications." Quaker Oats' purchase and subsequent sale of Snapple is a
good example of this common mistake.
A company should invest capital only in those businesses within its area of expertise. This is a difficult factor to screen for on a quantitative level. Before investing in a company, look at the company's past pattern of acquisitions and new directions. They should fit within the primary range of operation for the firm.
Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that
profitable opportunities exist. When companies have excess cash flow, Buffett favors
shareholder-enhancing maneuvers such as share buybacks. Buffett views share repurchases
favorably since they cause per share earnings increases for those who don't sell,
resulting in an increase in the stock's market price. This is a difficult variable to
screen as most data services do not indicate this variable. You can screen for a
decreasing number of outstanding shares, but this factor is best analyzed during the
valuation process. While we did not screen for this factor, a follow-up examination of a
company should reveal if it has a share buyback plan in place.
Have retained earnings been invested well?
Buffett examines management's use of retained earnings, looking for management that have
proven it is able to employ retained earnings in the new moneymaking ventures, or for
stock buybacks when they offer a greater return. A company should retain its earnings if
its rate of return on its investment is higher than the investor could earn on his own.
Dividends should only be paid if they would be better employed in other companies. If the
earnings are properly reinvested in the company, earnings should rise over time and stock
price valuation will also rise to reflect the increasing value of the business. Our other
screens for strong and consistent earnings and strong return on equity help to the capture
this factor.
An important factor in the desire to reinvest earnings is that the earnings are not subject to personal income taxes unless they are paid out in the form of dividends. The use of retained earnings delays personal income taxes until the stock is sold.
Is the company's return on equity above average?
Buffett considers it a positive sign when a company is able to earn above-average returns
on equity. Mary Buffett indicates that the average return on equity for over the last 30
years is approximately 12%. We created a custom field that calculated the average return
on equity over the last seven years. We then filter for companies with average return on
equity above 12%. An average return on equity for the last seven years should provide a
better indication of the normal profitability for the company, then just a current
snapshot. However, we also include a screen requiring that the current return on equity be
above 12% to help assure that the past is still indicative of the future direction of the
company.
Is the company free to adjust prices to inflation?
True consumer monopolies are able to adjust prices to inflation without the risk of losing
significant unit sales. This factor is best applied through a qualitative examination of
the companies and industries passing all the screens.
Does company need to constantly reinvest in capital?
In Buffett's view, the real value of consumer monopolies is in their intangibles-for
instance, brand-name loyalty, regulatory licenses, and patents. They do not have to rely
heavily on investments in land, plant, and equipment, and often produce products that are
low tech. Therefore they tend to have large free cash flows (operating cash flow less
dividends and capital expenditures) and low debt. Retained earnings must first go toward
maintaining current operations at competitive levels. This is a factor that is also best
examined at the time of the company valuation although a screen for relative levels of
free cash flow might help to confirm a company's status.
The above basic questions help to indicate whether the company is potentially a consumer monopoly and worthy of further analysis. However, stocks passing the screens are not automatic buys. Next week we conclude our examination with the issue of value.