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 Frontline (NYSE: FRO ) -- 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 a 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 Frontline 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 Frontline's earnings and free cash flow history:
Source: S&P Capital IQ.
Frontline's earnings and free cash flow have fallen considerably in response to the economic downturn. Net income has actually been negative over the past 12 months, mostly due to falling revenue and asset writedowns.
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.
|
Company
|
Debt-to-Equity
|
Return on Equity
|
Return on Equity (5-Year Average)
|
| Frontline |
470% |
(29%) |
57% |
| Teekay Tankers (NYSE: TNK ) |
75% |
0% |
16% |
| Ship Finance International (NYSE: SFL ) |
241% |
16% |
28% |
| Nordic American Tankers (NYSE: NAT ) |
19% |
(7%) |
7% |
Source: S&P Capital IQ.
Oil & Gas tankers are incredibly capital-intensive -- hence the high debt-to-equity ratios for Frontline, Teekay, and Ship Finance. (Nordic American requires less debt because it also tends to finance itself with equity.) It can also be a very competitive and cyclical business. After adjusting for their high debt-to-equity ratios, none of these companies generate especially high returns on equity with limited debt, and Frontline, Teekay, and Nordic American have suffered from the economic downturn.
3. Management
CEO John Fredriksen has been at the job for since 1997.
4. Business
Oil and gas storage and transportation isn't particularly susceptible to technological disruption, though demand can be quite sensitive to the economic climate.
The Foolish conclusion
So is Frontline a Buffett stock? Probably not. Although the company has tenured management and operates in a technologically straightforward industry, it doesn't particularly exhibit some of the other quintessential characteristics of a Buffett investment: consistent earnings and high returns on equity with limited debt. However, you can stay up to speed on Frontline's progress by adding it to your stock watchlist. If you don't have one yet, you can create a watchlist of your favorite stocks by clicking here.
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