The Oracle of Omaha, Warren Buffett, is often hailed as the world’s greatest investor but he doesn’t think of himself that way. He will tell you he is not an investor or stock analyst; he is a business analyst and buys businesses.
What happens when we turn his analytic framework at your business? In a must-read book for all business owners, Robert Hagstrom reveals Buffett’s wisdom for evaluating businesses. One of the most famous is that Buffett requires the business to be simple and easy to understand or he will not buy it.
There are more and can be organized into four categories. We’ll focus on the most important items in the first three categories.
- Business Tenets
- Management Tenets
- Financial Tenets
- Market Tenets
Does the business have a consistent operating history?
Buffett likes businesses that have been consistent performers. If your business is in need of a turnaround, then Buffett won’t buy even if the industry is poised for growth. “Severe change and exceptional returns usually don’t mix,” he says.
Does the business have favorable long term prospects?
Buffett is much more likely to answer yes to this question if the business sells a product or service that 1) is needed or desired; 2) has no close substitute; and 3) is not regulated. Buffett likes these types of companies because it is easier for them to raise their prices without fear of losing market share or volume.
Is the management rational?
While most people think of themselves as rational actors, but science has shown us to often act irrationally. Some owners hoard cash far beyond what the company needs for a rainy day fund. Those companies slowly wither because the owner is not reinvesting in it for future success. Some owners siphon cash flow out of the company for personal use. Those companies slowly wither for the same reason. Buffett will not buy a business that has demonstrated irrational uses of its cash.
Is management candid with the shareholders?
Buffett says there is a difference between what laws and regulations require owners to disclose about publicly held companies and what responsible executive actually disclose to the public. Do you have the courage to discuss failure openly? If so, Buffett likes that about you. “The CEO who misleads others in public,” he says, “may eventually mislead himself in private.”
Does management resist the institutional imperative?
The institutional imperative exists when 1) a company resists change; 2) just as work expands to fill available time, corporate projects will materialize to soak up available funds; 3) yes men will support even foolish business cravings of their leader; and 4) the company begins to imitate its peers mindlessly in expansion, acquisition or other endeavors. Basically, if you make business decisions because you see other businesses doing something or are afraid to act differently than similar businesses, Buffett frowns on your actions because they do not lead to business success. Businesses must differentiate themselves from their competition, not imitate them.
Look for companies with high profit margins.
Buffett has little patience for owners who allow costs to escalate. Have you been keeping a watchful eye on the costs of the goods you sell? If not, they’ve been creeping up without you adjusting for them. Now you have less gross profit left over than three years ago with which to pay your overhead. If you’re wondering why your profitability has been slipping, this is one of the first places to look. If you continuously cut costs (without hampering the business’s ability to sell) and you price your product or service well, you’ll have healthy margins with which to pay overhead and maintain the health of the company.
These principles are not difficult to understand, in fact, they are quite ordinary. Above average results are often produced by doing ordinary things. The key is to do them exceptionally well. Implement these ideas in your business today. Transform it into something Warren Buffett would smile on.