Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have never put out a definitive checklist for finding good quality companies, probably because there isn't one.
But over the years they have issued plenty of advice on how to find the market's best companies and what price investors should be paying when they invest.
Light on yardsticks
For example, in one Q&A session, a Berkshire Hathaway shareholder asked Munger how he and Buffett go about evaluating potential acquisition candidates. Munger responded:
"We’re light on financial yardsticks; we apply lots of subjective criteria: Can we trust management? Can it harm our reputation? What can go wrong? Do we understand the business? Does it require capital infusions to keep it going? What is the expected cash flow? We don’t expect linear growth; cyclicality is fine with us as long as the price is appropriate."Â
The quote above does not set out any quantitative factors for investors to use when they are finding potential investments, but it does give some qualitative factors, particularly the importance of return on capital and cash generation. Both of these Munger and Buffett have spoken about at length before.
According to Munger, it all comes down to how much cash an investor can take out of the business. If a company earns a significant return on capital, and investors can withdraw cash generated at the end of the year, then this is a highly attractive business model. If, on the other hand, the company has to reinvest this capital, then that is a bad business model Munger and Buffett are not particularly interested in.
"There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested— there’s never any cash. It reminds me of the guy who sells construction equipment— he looks at his used machines, taken in as customers bought new ones, and says, 'There’s all of my profit, rusting in my yard.' We hate that kind of business." -- Charlie Munger (Trades, Portfolio)
Pricing power is also vitally important for maintaining a high return on invested capital. Companies that have significant pricing power are rare, and when you come across them, according to Munger you should act as swiftly as possible to make the most of the opportunity. Disney and Coca-Cola are both great examples:
"There are actually businesses that you will find a few times in a lifetime where any manager could raise the return enormously just by raising prices— and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot, and the attendance stayed right up…Once you figure that out, it’s like finding money in the street— if you have the courage of your convictions." -- Charlie Munger (Trades, Portfolio)
This is not designed to be a definitive guide on how to find attractive investments, but these three quotes from Munger give some invaluable insight into his investment process and provide an excellent framework for investors to use themselves.
These quotes will not give you a surefire way to investment success, but they should point you in the right direction -- or at least point you away from the wrong direction.
Disclosure: The author owns shares in Berkshire Hathaway.
