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 SandRidge Energy (NYSE: SD ) -- 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 this series, we do just that.
Writing 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 SandRidge 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 SandRidge's earnings and free cash flow history:
Source: S&P Capital IQ.
SandRidge has had difficulty producing earnings and free cash flow over the past five years. However, it's important to note that the large net-income losses in 2008 and 2009 were due to asset impairment charges and that the free cash flow shortfalls are due to major capital investments the company has been making. Operating cash flow has been fairly steady.
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
5-Year Average Return on Equity
Source: S&P Capital IQ.
For the reasons discussed above, SandRidge hasn't generated very high returns on equity over the past few years. The company carries moderately high amounts of debt and generated a reasonable return on equity over the past year. Ultra Petroleum carries a fairly significant debt-to-equity ratio, while Whiting Petroleum hasn't generated particularly high returns on equity. From this metric's perspective, Continental Resources is the only one that seems to pass the test.
CEO Tom Ward has been at the job since 2006. Prior to that, he was CEO of Integra Energy and founded Chesapeake Energy in 1989.
Though new technologies are being developed in the industry, oil and gas exploration and production isn't particularly susceptible to technological disruption.
The Foolish conclusion
So is SandRidge a Buffett stock? Probably not. The company has a tenured CEO and operates in a fairly straightforward industry, but it doesn't yet particularly exhibit the other characteristics of a quintessential Buffett investment: consistent earnings (unless we consider operating cash flow) and high returns on equity with limited debt. To stay up to speed on SandRidge's progress, simply add it to your stock watchlist. If you don't have one yet, you can create a watchlist of your favorite stocks by clicking here.