Time is the friend of the wonderful company, the enemy of the mediocre↓
If you know anything about Warren Buffet, you know he loves investing in great companies.
In fact, he and Charlie Munger's entire investing strategy centers around finding great companies at fair prices. But what does that entail? While I'm positive Buffett can explain that better than me, I'm still going to take a shot at it.
“Time is the friend of the wonderful company, the enemy of the mediocre.” — Warren Buffett
Buffett and Munger are huge on investing in “wonderful” companies, and one of the most important aspects of that is solid management. That being said, how do you verify if management is trustworthy and/or capable? A few ways:
Most great companies, and investments, all have the ability to produce above-average profits. As Buffett states, “We prefer demonstrated consistent earning power.” The 3 main ones to look at are:
As for a moat, otherwise known as a competitive advantage, there are two excellent metrics I like to analyze to determine if one exists, Return on Equity (ROE) and Return on Invested Capital (ROIC). Look for a ROE and ROIC of greater than 15% for at least 5 years, preferably 10.
Why, you ask? Well as I have previously written, in one of Berkshire Hathaway's letter to shareholders Buffett mentions they use 2 tests to determine economic excellence. The 1st being the company had to have 10 years of a return on equity greater than 20%, and the 2nd stating the company couldn’t have any year worse than 15%. As you can imagine, not many companies fit the bill. According to a Fortune Magazine study, only 25 firms out of 1,000 passed from 1976 to 1986. The most astonishing number is 24, as in 24 out of the 25 companies outperformed the S&P 500 during that timeframe. And since ROIC is close related, you should pay close attention to these metrics, they can tell you a lot.
A company can have great earnings, positive cash flow, growing sales, and still be in trouble if they are weighted down by too much debt. Which is why it's crucial to scour the balance sheet and look for problem areas.
Two metrics to identify are Debt to Equity and the Current Ratio. The debt to equity ratio identifies if the company is being financed too heavily with debt. Obviously companies with lower debt/equity ratios are preferable (ideally < 0.5). The current ratio identifies if the firm can meet short-term obligations with short-term assets. Higher the better (ideally > 2).
But don't stop there, head over to YourPortfolio Software and check out the company's free cash flow. Not only should this number be positive, but steadily increasing as well.