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Buffett's Search for the Next Wal-Mart

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Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) Chairman Warren Buffett places a premium on finding companies with excellent management. How can investors evaluate management? What questions should investors ask? And what makes Buffett's temperament different from other investors? I recently asked Georgetown University McDonough School of Business professor Prem Jain, author of Buffett Beyond Value: Why Buffett Looks to Growth and Management When Investing.

Mac Greer: Your book talks about how important management and the "people side" of investing are to Buffett. What specific suggestions do you have for individual investors trying to assess the management of the companies they've invested in or are considering investing in?

Prem Jain: Evaluating company management or a CEO is not easy because different individual qualities can engender success in different circumstances. But I can certainly tell you two fundamental questions to ask. First, are the management team and the current CEO competent? Second, are management incentives properly aligned with shareholder interests?

To answer the first question, I review the company's performance over several years. For example, when I evaluated Johnson & Johnson (NYSE: JNJ  ) and its management, I examined the company's earnings, the return on equity, and the allocation of cash flows for more than 25 years. I prefer evaluating a company's performance over a long period to discover whether management teams can deliver positive results under different CEOs. While it is important to evaluate several metrics, a carefully computed return-on-equity ratio is probably the most important metric for determining management competence. I found consistently good performance over the entire period, and I did not spot any incongruent acquisitions, large equity issuances, or egregious ethical violations. To me, the results reflected disciplined management. I also read all of the CEO William Weldon's letters to shareholders since he was appointed in 2002.

To answer the second question, I check the number of shares held by the CEO and other top managers in the company. I am suspicious of CEOs who are awarded a large number of stock options but hold only a small number of shares. In addition, I prefer CEOs who have been with the company for a long time and are promoted from within. They should at the very least have experience in the same industry. Finally, I try to learn about their lifestyle. A CEO with an extravagant lifestyle is less likely to be prudent with shareholders' money than a CEO who lives more modestly.

Since there is no exact science to evaluating management teams or CEOs, it is important to give yourself a lot of practice. To develop your evaluation skills, I recommend finding several inarguably good CEOs and studying them and their companies. Beyond Warren Buffett, I have benefited from reading articles about and written by Alfred Sloan [former chairman and CEO of General Motors], Jack Welch [former chairman and CEO of General Electric (NYSE: GE  ) Sam Walton [founder of Wal-Mart (NYSE: WMT  ) ], Jim Sinegal [co-founder and CEO of Costco (NYSE: COST  ) ], and several others. An investor can evaluate a CEO or the management team properly only if he or she has first studied many CEOs and management regimes that are known to be successful. The good news is that because there is considerable amount of art in evaluating management, the evaluator gets better with time. 

Greer:  Warren Buffett's been quoted as saying temperament -- not intellect -- is the most important quality an investor can have. What makes his temperament different than everyone else's on Wall Street?

Jain:  Warren Buffett's most important quality, I believe, is his focus on the long term. He does not pay much attention to what the so-called experts are predicting about the next year or two. Most people in the market are seeking short-term returns. When there is some bad news, far too many people react negatively and the stock market goes down. Similarly, people become euphoric en masse from time to time, which often produces bubbles. Buffett's levelheaded temperament allows him to weather these fluctuations.

Having a long-term view becomes a tremendous advantage in a world where most others are short-term oriented. When the herd of short-term investors moves the market, the independent-minded long-term investors can take the opposite side and eventually earn superior returns.

The secret of Buffett's success in finding companies that give solid returns year after year also lies in his focus on the long term. Because most people are looking for instant gratification, stocks of exciting companies in trendy sectors (such as solar energy companies recently or dot-com start-ups earlier) get overvalued. On the other hand, excellent companies such as Wal-Mart, Johnson & Johnson, and Berkshire Hathaway are often undervalued. The remarkable thing is that such companies often remain undervalued for a very long period of time. Consider Berkshire's annualized return on equity of about 20% for the past four decades. During this period, it was clear that Berkshire would earn a high return on equity for years. However, the market almost never took Berkshire's underlying business performance into consideration to price its stock. Consequently, Berkshire's stock remained undervalued for decades. In the meantime, it gave high returns to its shareholders. To me, Berkshire still seems to be undervalued for the same reason.  

Overall, well-managed, boring companies remain undervalued for extended periods because most investors are rarely enthusiastic about those companies. Buffett is different. Instead of searching for the next Google or the next Apple, he searches for the next Wal-Mart.

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Mac Greer owns shares of Costco. Berkshire Hathaway is a Stock Advisor recommendation and an Inside Value recommendation. Costco is a Motley Fool Inside Value and Stock Advisor selection. Wal-Mart is also a choice of Inside Value. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway, Costco, and Wal-Mart.  The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (11)

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  • Report this Comment On September 28, 2010, at 11:24 PM, Smarsonmania wrote:

    "Overall, well-managed, boring companies remain undervalued for extended periods because most investors are rarely enthusiastic about those companies. Buffett is different. Instead of searching for the next Google or the next Apple, he searches for the next Wal-Mart."

    Why are good companies boring? Isn't it exciting to invest in GE at 5 bucks I sure found it exciting. Or Wells Fargo at 8?

    Why does everyone associate exciting with investing in Netflix at 160. Is it so exciting to throw money away?

  • Report this Comment On September 28, 2010, at 11:24 PM, Smarsonmania wrote:


  • Report this Comment On September 29, 2010, at 12:59 AM, Mstinterestinman wrote:

    People tend to think the next big thing is a quick way to get rich in the stock market too often they invest in that even if the company isnt very well run. Netflix is a great company imo GE isnt anymore its not a bad company but GE Capital and NBC add alot of negatives to its industrial parts.

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