It was Boxing Day 2009 and I was spending Christmas at my home in Florida when the phone rang.
It was David Clark in Omaha, Nebraska. Dave said he and Mary Buffett, joint authors of the “Buffettology” series of investment books, were looking to licence the name to be used for fund management in Europe and would I consider being the fund manager?
It took me a nanosecond to agree. My agreement with them requires me to manage the fund in accordance with the tenets of the book Buffettology. What does this mean in practice?
The core idea is that when you buy a share you’re buying an economic interest in a real company, rather than gaming chips at a casino. This struck me as eminently sensible.
What it entails is to switch off extraneous factors such as trying to predict where markets, the economy or interest rates are going and to spend all your time on a company’s business, the industry it serves and the competitive market in which it operates.
The framework I use for this is Michael Porter’s “five forces” analysis. The five forces are: the bargaining power of customers; the bargaining power of suppliers; the industry’s competitive landscape; the threat of new entrants; and the threat of substitute products.
This analysis is at the heart of the economic “go/no-go” decision at the start of every investment idea I might pursue.
Right at the top, I’m looking for companies with an “economic moat” (a Buffett term that expresses how well a business is protected from competition). These rare concerns are consistently able to earn much higher returns on each pound of capital invested in them.
Companies that can do this – and that you believe will continue to do it – have something very special. Much of my research is assessing the strength of the walls, barriers and drawbridges that have kept the competition at bay.
Ideally, I’m looking for companies, industries and markets that have solid growth prospects, so they can benefit both from overall market growth and from gains in market share.
I’m not overly fussed about explosive growth; businesses that can steadily compound revenues at, say, 5pc, 6pc or 7pc make wonderful investments if held for a long period.
I pay a lot of attention to the development of profit margins. From using economies of scale and increasing bargaining power, businesses should see their margins steadily improve as they grow. Margins that are flat or declining suggest to me that the economic power of the franchise is waning – most definitely to be avoided.
But more important than profit margins (profitability relative to sales) is profitability relative to the amount of capital invested in the business. I want those returns to be a high-teens percentage or more. But I need them to be “cash” returns, not “accounting returns” or reported profits.
Cash returns can differ from reported profits in a number of ways. For example, money tied up in stock in the warehouse and credit advanced to customers demands upfront cash that doesn’t get offset against sales.
You may have made the profits but the actual cash you received is tied up. I take more notice of cash returns because it’s cash that can actually be reinvested in the business, used for bolt-on acquisitions or handed back to shareholders through dividends (or share buybacks).
I am typically not interested unless the business is converting at least 80pc of its profit after tax into free cash flow. That often leads me to invest in “asset-light” businesses, whose returns depend less on physical assets and more on intangibles such as intellectual property, know-how or “human capital” – skills.
The last thing I’d highlight is an emphasis on businesses that are predictable to a higher than normal degree of certainty. By that I don’t mean you can predict earnings with precision, but more that the characteristics of the business are going to be substantially the same in 10 or even 20 years’ time.
Think of Diageo and its premier global roster of spirits brands. In general, teetotalism isn’t likely to break out globally.
There’s also a direct correlation between a country’s GDP per capita and the consumption of spirits, so you can imagine developing markets firing additional demand over time. This is not a business I’d expect to be fundamentally disrupted any time soon.
I want to finish by mentioning rational capital allocation by company managers – their most important task. When it comes to capital allocation, I always ask myself if the people running the business are acting like owners of the business or as expensively paid management consultants.
I want owners, and my preferred choice on capital allocation is reinvestment into new projects that generate organic growth at high rates of return. This use of capital is the simplest to manage. My next best use of capital would be bolt-on acquisitions that perhaps add new expertise, new products, new technologies or new markets.
I’m wary of “transformational” acquisitions. There’s a horrible temptation for a professional company manager with excess cash to go out and splash it, buying something big to make his or her name. I’d prefer that they hand it back to the owners whenever it’s truly cash that can’t be put to better use.
