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 Southwest Airlines (NYSE: LUV ) -- 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 Southwest 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 Southwest's earnings and free cash flow history:
Source: S&P Capital IQ.
Although earnings and free cash flow have fluctuated a bit over the past few years, they've been remarkably consistent given the economic downturn and the comparison with competitors.
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.
Southwest generates modest returns on equity -- 4% over the past year, 5% on average over the past five years -- while employing a moderate 47% debt-to-equity ratio. Those numbers may not seem that impressive, but even producing those returns is exceptional for a competitive and capital-intensive industry like airlines.
CEO Gary Kelly has been at the job since 2004. Prior to that, he had been the company's chief financial officer since 1989.
Airlines aren't particularly susceptible to wholesale technological disruption. Though, as we've seen, it's a highly competitive industry -- one reason why Buffett has cautioned against investing in it in the past.
The Foolish conclusion
So is Southwest a Buffett stock? Probably not, because of its low-moat and capital-intensive industry and the low returns on equity it generates. That being said, the airline is a standout as far as the industry goes, exhibiting fairly consistent earnings, positive returns on equity with limited debt, and tenured management. To stay up to speed on Southwest'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.