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 Hewlett-Packard (NYSE: HPQ ) -- 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 Hewlett-Packard 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 Hewlett-Packard's earnings and free cash flow history:
Source: S&P Capital IQ.
Hewlett-Packard's earnings have remained pretty consistent over the past several years.
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-to-equity ratio, 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
|IBM (NYSE: IBM )||155%||73%||61%|
|Cisco (Nasdaq: CSCO )||34%||15%||20%|
Source: S&P Capital IQ.
Although not as strong as some of its peers' returns on equity, Hewlett-Packard is reasonably profitable. It has highly lucrative services and printer divisions. Hardware businesses that can charge for services are generally great places to be. IBM and Cisco are well known for their lucrative services businesses. In fact, last year, Buffett purchased $10.7 billion of IBM shares, largely on account of its enormously profitable and sticky services business. Still, Hewlett-Packard probably lags behind the other three when you take into account its moderately large debt-to-equity ratio.
Over the past couple of years, Hewlett-Packard became virtually synonymous with rapid executive turnover and hurried decision-making at the board level. Within a short period, we saw Mark Hurd and Leo Apotheker each leave the company with golden parachutes. The current CEO, Meg Whitman, was a longtime eBay CEO and has been at the job since last September. In short, Buffett probably wouldn't be too enamored with the company's recent corporate-governance issues.
The hardware business is notoriously susceptible to technological change and disruption. It came as a surprise to many when Buffett made his IBM purchase.
The Foolish conclusion
So, is Hewlett-Packard a Buffett stock? Probably not. Although it does produce consistent earnings, it doesn't yet particularly exhibit the other quintessential characteristics of a Buffett investment: high returns on equity with limited debt, tenured management, and a technologically straightforward industry. However, if you're interested in a stock that our top analysts and chief investment officer picked to beat the market, you can check out "The Motley Fool's Top Stock for 2012." I invite you to download this special report for a limited time -- it's free.