Buffett's test of economic excellence

In his 1987 letter to Berkshire Hathaway shareholders, Warren Buffett wrote about two tests of economic excellence that he performed on that year's Fortune 1,000 companies. The two tests were:
1. An average ROE of over 20 per cent in the last ten years.
2. No year worse than 15 per cent.

We conducted this test for listed Indian companies for two decades: from FY03 to FY12 and from FY13 to FY22 (for FY22, we used the latest value available). Here are the findings.

From FY03 to FY12

• Of the 1,589 companies with a 10-year history, only 91 companies cleared the test, i.e., about 6 per cent of the total.
• Nearly 50 per cent of the companies that cleared the test were from the healthcare (13), FMCG (12), automobile (10) and IT (eight) sectors.
• Of these 91 companies, only 37 were able to beat the BSE 500's 10-year return of 13.3 per cent.
• However, if one were to create an equal-weighted portfolio of these companies, then the 3-year, 5-year and 10-year return (from May-end 2012) of this portfolio would have been 25.5 per cent, 16.7 per cent and 13 per cent, respectively. Thus, one would have beaten the BSE 500 over 3Y and 5Y periods.

From FY13 to FY22

• Of the 1,134 companies with a 10-year history, only 95 companies passed the test, i.e., around 8 per cent of the companies.
• This time 60 per cent of the companies that cleared the test were from the chemical (16), IT (14), FMCG (14) and healthcare (13) sectors.
• Only 28 companies from the previous list were able to clear the test for the second time after a decade. 10 of these 28 companies belong to the FMCG sector.
• Had one invested in only these 28 companies in May 2012, the 10-year return would have been 15.9 per cent.
• None of these 28 companies has a debt-to-equity ratio of more than one. Most have a high dividend-payout ratio implying the lack of high reinvestment requirement or opportunity and shareholder-friendly capital allocation.

A common trait across companies that cleared the tests is that they have not undergone a significant change in their operations. Most of these companies have continued to build on their businesses and focused on strengthening their position. It is a remarkable feat to clear the test twice over two decades. However, one shouldn't look at the list below and simply extrapolate the past to assume assured returns. Given the high churn in the number of companies able to clear the test, it would be unwise to do so without proper due diligence.

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