How to build your Buffett portfolio in 2016

Author Robert Hagstrom in his bestselling book The Warren Buffett Way identified 12 tenets which he believes Warren Buffett utilises in his investment process. In this recent article I discussed three Business tenets, this was followed here by a review of three Management tenets.

Now it’s time to turn our attention to four Financial tenets…

1. What is the Return on Equity?

Warren Buffett utilises the return on equity metric for determining the value of a company because he is seeking to identify quality companies that can achieve above average rates of return for their shareholders.

Buffett believes that in the long-run it’s the firms that can maintain above average ROE that will outperform.

While investors can determine ROE for themselves, it is interesting to note that few companies regularly report their ROE. National Australia Bank Ltd (ASX: NAB) and indeed most banks regularly report their cash ROE to investors.

Woolworths Limited (ASX: WOW) reports return on funds employed (ROFE), which is a slightly different metric to ROE but does allow for a similar determination of quality to be analysed.

2. What are the company’s ‘owner earnings’?

Accounting rules require companies to make judgements about how to present earnings results. Sometimes reported earnings fail to give investors a clear picture of the “real” earnings that an owner can expect to receive. For this reason, Buffett adjusts reported earnings to give himself a clearer picture.

To a large degree it is now commonplace for companies to provide their own view of “owner earnings” in the form of “underlying earnings”. These show the adjustments which management think need to be made to provide investors with a clearer picture of operating results.

3. What are the profit margins?

Profit margins are important for all firms but can vary a lot. While many industrial businesses operate with profit margins between 5% and 10%, other firms such as SEEK Limited (ASX: SEK) can operate with margins above 20%.

According to Hagstrom, for Buffett the key when analysing profit margins is to determine if management is being as efficient with shareholders’ capital as it can be.

4. Has the company created at least one dollar of market value for every dollar retained?

Buffett is exceptionally good at profitably allocating capital and only wants to invest in firms that allocate capital efficiently too. Buffett determines this skill by analysing whether for each dollar retained by a company, a dollar of market value has been gained.

Some companies have been exceptionally good at creating value for shareholders, Domino’s Pizza Enterprises Ltd (ASX: DMP) and REA Group Limited (ASX: REA) are two examples where every dollar retained by the company has led to more than a dollar gained in market value.

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Motley Fool contributor Tim McArthur has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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