As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.
We can't know for sure whether Buffett is about to buy Paychex (Nasdaq: PAYX ) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us.
In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno-mumbo-jumbo businesses.
Does Paychex meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Paychex's earnings and free cash flow history.
Source: Capital IQ, a division of Standard & Poor's. Free cash flow is adjusted based on author's calculations.
Over the past five years, Paychex's earnings and free cash flow have been fairly consistent.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.
Return on Equity (LTM)
Return on Equity (5-Year Average)
|Automatic Data Processing (Nasdaq: ADP )
|Fiserv (Nasdaq: FISV )
|Global Payments (NYSE: GPN )
Source: Capital IQ, a division of Standard & Poor's.
Paychex produces superior returns on equity to its peers while employing no debt.
CEO Martin Mucci has been at the job for almost a year. Before that, he was the senior vice president of operations for several years.
Data processing uses technology, but it isn't particularly susceptible to wholesale technological disruption.
The Foolish conclusion
Regardless of whether Buffett would ever buy Paychex, we've learned that it exhibits many of the characteristics of a quintessential Buffett investment: consistent earnings, high returns on equity with limited debt, and a straightforward business.
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