One of the most popular themes in our blog posts this year has been that of small caps. Here, we look at how our dividend index methodology connects with the way Warren Buffett looks at potential acquisitions, key aspects being:…
For Professional Clients & Sophisticated Investors
Berkshire Hathaway Inc. Acquisition Criteria
• Demonstrated consistent earnings power
• Businesses earning good return on equity (ROE) while employing little or no debt
The key phrase is “businesses earning good returns on equity while employing little or no debt.” However, the quality discussion within equity investing has a long history, and Warren Buffett certainly isn’t the only one to mention it.
Benjamin Graham’s Quality Criteria
One of Warren Buffett’s teachers, Benjamin Graham, who is known as one of the fathers of value investing, also had a rigorous focus on quality traits. Many focus on Graham’s criteria for finding inexpensive companies, but he was at least equally focused on attributes of quality, if not more so.
Benjamin Graham’s Attributes of Quality
• “Adequate” enterprise size, as insulation against the “vicissitudes” of the economy
• Strong financial condition, measured by current ratios that exceed 2 and net current assets that exceed long-term debt.
• Earnings stability, measured by 10 consecutive years of positive earnings
• A dividend record of uninterrupted payments for at least 20 years
• Earnings-per-share growth of at least one-third over the last 10 years
Fama-French Operating Profitability Factor
Research done by Kenneth French and Eugene Fama arrives at a similar place. In their research piece “A Five-Factor Asset Pricing Model” from September 2014, they cite operating profitability, defined as annual revenues minus cost of goods sold, interest expense and selling, general and administrative (SG&A) expenses, all divided by book value of equity. Note, this is similar to Buffett’s criteria above: a company earning a good return (profits) on its equity (book value)—in other words, a high ROE. Arranging the U.S. market into quintiles based on operating profitability further emphasizes that high-quality stocks have won over longer holding periods.
The Spectrum of Operating Profitability Quintiles from June 30, 1963, to June 30, 2015
Top Two Quintiles Outperformed the Market:We saw the top two quintiles outperform the market on two fronts—average annual returns andSharpe ratio. In other words, this outperformance was not achieved with a significant increase in risk.
Grantham on Why Quality May Outperform over Long Periods
One of the long-standing investment practitioners of quality investing has been Jeremy Grantham’s firm, GMO. In a paper written in 2004, GMO wrote of quality firms:
“… even though many of these corporations tend to generate high profits year after year, they are systematically underpriced because they lack volatility. Instead of overpaying for these companies, as finance theory would suggest—given their low risk profile—shareholders in fact do just the opposite: they underpay. The result is that investors in high-quality companies get to forge ahead with 15+% returns year after year without overpaying. Of course, in any given year, low-quality stocks can and do stage rallies and high-quality stocks can underperform. But the high-quality stocks have always won over longer holding periods. No matter what metric is used to identify quality stocks—leverage, profitability, earnings volatility or beta—high-quality stocks have beaten out low-quality stocks.”
In other words, the desire to try to find that “next big thing” tends to exert so much power over the investment psyche that focusing on quality companies has, at least historically, been one avenue through which to achieve outperformance.
 Source: Berkshire Hathaway annual letter to shareholders from Warren E. Buffett, 2/28/15.
 Source: Benjamin Graham, “The Intelligent Investor” (4th revised edition), Harper & Row, 1973.
 “The Case for Quality—The Danger of Junk,” GMO white paper, 3/04.