As usual, this year's letter by Chairman Warren Buffett to shareholders of Berkshire Hathaway (NYSE: BRK-A ) is required reading for any serious investor.
In the section titled "Businesses -- The Great, the Good, and the Gruesome," Buffett succinctly shares the secrets of his investing success. He and longtime partner Charlie Munger look for companies that have ...
- A business they understand.
- Favorable long-term economics.
- Able and trustworthy management.
- And a sensible price tag.
Over the years, many people, including myself, have tried to replicate Buffett's investing strategy. I can't speak for others, but I know I've been too often guilty of focusing on valuation at the expense of the quality of the business. Perhaps that's why Buffett is the world's richest person, worth around $62 billion, and I'm struggling to get to my first billion.
So where are these high-quality companies? In this year's letter, Buffett mentions Costco (Nasdaq: COST ) as an example of a low-cost producer with a formidable barrier to entry. Longtime Buffett holdings Coca-Cola (NYSE: KO ) and American Express (NYSE: AXP ) are mentioned as companies possessing a powerful worldwide brand.
But there's no mention of how Buffett might calculate a "sensible price tag." That's because, for Buffett, it likely depends on the quality of the business.
According to this year's letter, his dream business is one with "an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft (Nasdaq: MSFT ) and Google (Nasdaq: GOOG ) ."
Buffett turned on by Google
Bill Gates and Warren Buffett are close personal friends. Gates sits on the Berkshire Hathaway board, and Buffett has pledged to donate most of his personal fortune to the Bill and Melinda Gates Foundation.
Despite the mutual friendship, and despite his admiration for Microsoft, the Oracle of Omaha has never invested a meaningful stake in the company. As reported by Robert Miles, Buffett says this is because he doesn't know the company well enough and can't confidently predict where computers will be 10 years from now.
But what about Google? Considering that he included Google in the section of his letter that begins "Let's take a look at what kind of businesses turn us on," you have to assume Buffett is an admirer.
But as much as he may admire it, he'd probably never make an investment in the company. As with Microsoft, he probably doesn't know the company well enough and can't predict what Google might look like five or 10 years from now.
Is that a mistake? It could be.
The Buffett test
Let's run Google through Buffett's four secrets to investing success.
1. A business I understand.
The main driver of the Google business is its dominance of electronic search-engine advertising and its ability to target paid advertising as a result. Google continues to take market share from its nearest rival, Yahoo! (Nasdaq: YHOO ) , a situation I expect to continue regardless of whether Microsoft takes it over. As search and targeting technology both improve, ad dollars will keep flowing to the company.
2. Favorable long-term economics.
Online is here to stay. Both in the United States and around the world, more and more people are going online as broadband access penetrates the corners of the world. Then there's mobile interest, which, while promising, is in its infancy. But it should prove to be an additional growth driver for Google.
3. Able and trustworthy management.
CEO Eric Schmidt and co-founders Sergey Brin and Larry Page have done an outstanding job to date. In an interview with Fortune magazine in the summer of 2004, just before Google's initial public offering, they made a pact to work together for 20 years. Not only are they clearly able and trustworthy, they have committed their working careers to Google (and they own a ton of the stock, too). Enough said.
4. A sensible price tag.
Google trades for approximately 20 times next year's estimated earnings. Given its dominant position in a growing industry, its large profit margins, and its lean business model, 20 times forward earnings isn't an unreasonable price tag. Of course, Google looks a bit more rich in other metrics, so "sensible" may be in the eye of the beholder.
While it comes close to meeting all four criteria, given Google's current valuation, Buffett is probably taking a wait-and-see attitude toward the company -- no matter how much it turns him on.
That said, the next time you find a stock that turns you on, consider running it through Buffett's four-step test. If it passes with flying colors, you may be on to something.
What turns a Fool on
Motley Fool co-founder David Gardner is turned on by "consumer-facing technology companies." David heads Motley Fool Rule Breakers, an investing service dedicated to growth stocks.
Though their investing styles are not identical, David, like Buffett, loves to find companies possessing an ever-increasing stream of earnings with virtually no major capital requirements and favorable long-term economics -- companies just like Google.
If you want to see what stocks David likes right now, a free 30-day trial of Rule Breakers gets you access to all of the team's recommendations, including their top five for new money now. (Google's not one of them, but they might turn you on anyway.)
Bruce Jackson is turned on by his holding in Berkshire Hathaway. Bruce doesn't own any other companies mentioned in this article. The Motley Fool also owns shares of Berkshire Hathaway. Berkshire is an Inside Value and Stock Advisor recommendation. Costco is a Stock Advisor pick. Microsoft and Coca-Cola are Inside Value recommendations. The Motley Fool's disclosure policy is a turn-on.