Investing well is about buying quality stocks when they trade at bargain prices. And Warren Buffett has a distinctive test for identifying these.
Todd Combs – one of the portfolio managers at Berkshire Hathaway – describes three features Buffett looks for in a stock to buy. I think there’s a UK company that might make the grade.
Three steps to heaven
The test itself is reasonably simple. In order to pass, a business needs to meet the following conditions:
- Trade at a forward price-to-earnings (P/E) ratio below 15.
- Have a 90% chance of making more money five years from now.
- Have a 50% chance of growing at 7% a year.
The first condition rules out stocks that are overpriced. A P/E multiple below 15 means investors buying the stock start with an earnings yield of 6%, giving a reasonable return at the outset.
The second condition rules out businesses whose earnings are high for some unusual or unsustainable reason. In these cases, it’s difficult to be confident that their earnings will be higher five years from now.
Lastly, the third condition rules out companies with no growth prospects. While 7% a year is almost never guaranteed, it needs to be a realistic possibility at least.
JD Wetherspoon
Passing Buffett’s test is surprisingly difficult. But I think shares in JD Wetherspoon (LSE:JDW) might have a decent shot.
The first condition’s a little tricky. It’s impossible to know precisely what the company’s future profits will be, so there’s inevitably some uncertainty over the forward P/E ratio.
That said, a number of sources indicate the multiple to be somewhere around the 15 mark or a bit either side. There isn’t much margin of safety here, but I have the stock passing the first part of the test.
The next two conditions are about where the business is going from here. To figure this out, investors need to look at the company’s competitive position.
Outlook
I actually think the second condition’s relatively straightforward for JD Wetherspoon. The company’s working to reduce its lease obligations and costs by focusing on operating fewer – but larger – venues.
Revenues have been increasing despite the reduction in pub numbers, which is a very encouraging sign. Furthermore, the firm’s scale allows it to negotiate lower prices than its rivals from suppliers.
These advantages seem durable and make me confident the company will make more money five years from now. Whether this is enough to support 7% annual growth though, might be another question.
The biggest risk’s inflation – higher prices for utilities, staff, and products are a challenge for a business focused on low prices to consumers. And that makes the third condition less clear.
50/50
It’s worth noting that Buffett’s third condition involves a 50% probability. I certainly wouldn’t say the company growing at this rate’s a certainty, but I wouldn’t rule it out.
If lower interest rates can boost the UK economy, I think the company has a decent chance. So I’d suggest the stock passes Buffett’s test – which is why I’ve been buying it for my portfolio.
