Read on to understand the three business tenets that Warren Buffett checks and follows before committing to a company
Warren Buffet has some principles that he follows religiously throughout the years while looking at or even considering to look at a company. In the book 'The Warren Buffet Way', author Robert G. Hagstrom has summarised them as tenets of Warren Buffet. There are twelve tenets in total under different categories. In this four-part series, we will be looking at each category, starting with business tenets.
Simple and understandable
What does simple and understandable mean? Should you pick only easy companies? No. It means investors should thoroughly understand the company they are investing in. Nature of industry, business model, revenue sources, regulations, whether the company has pricing power, competition, raw materials, etc., should be some aspects that investors should study and understand. Why does he emphasise this? Since we wish to remain invested in the company for a longer period of time, we can evaluate its future trajectory only if we understand the company thoroughly. This is the reason why he delayed his investment in Apple. It also helps us understand the developments that are taking place both in the company and the industry. Five factors can help you understand a company's environment.
Consistent operating history
Warren Buffet avoids investing in companies that are solving difficult business problems or pivoting towards a new direction because what the company has right now does not work. He adores companies that have been involved in the business of providing the same product or service for years. Only if a company has a steady track record, can you predict where the business is going. That is also the reason why Warren Buffet is not a fan of turnarounds. While it can be a huge money maker if invested correctly, many can be wealth destroyers too.
Favourable long-term prospects
Buffet divides companies into two categories. The first is a small group of great companies that he refers to as 'franchises'. The second is a large group of mediocre companies that are not worth purchasing. A franchise is a company that provides a product or service that is:
1. Needed or desired by the public,
2. Has no close substitute, and
3. Is not highly regulated.
If a company has these traits, then it gives them higher pricing power, and with higher pricing power comes an above-average return on capital. This will create what Buffet calls 'Moat' which gives the company a competitive advantage. Mediocre companies are those that produce homogenous products that cannot be differentiated much. This results in poor and/or inconsistent profitability.
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