Warren Buffett is famous for keeping many billions of dollars in cash on Berkshire Hathaway's balance sheet so he always has the ability to make a needle-moving acquisition. Berkshire's cash balance exceeded $68 billion as of the end of September. So what stocks could Buffett be considering now?
We're not mind-readers, but Buffett does give us a great deal of insight into his acquisition criteria in his annual letter to shareholders:
- Large purchases (defined as at least $75 million in pre-tax earnings).
- Consistent earnings power, not just future potential.
- Strong return on equity, with little or no debt.
- Management in place.
- A simple business.
- An offering price.
We can largely ignore the last list item, since as retail investors, every stock available to us has an offering price. (Although, like Buffett, who is often considering buying entire companies outright, we should still determine if the price is reasonable before considering a purchase.)
Using the first five items on the list gives us a pretty good idea of whether Buffett could potentially be interested in a given company. Let's see how the biotech behemoth Gilead Sciences (NASDAQ:GILD) stacks up against his checklist.
1. At least $75 million in pre-tax earnings
Berkshire's market cap currently exceeds $380 billion, so Buffett is no longer interested in small deals that wouldn't have much of an impact on the company's financial statements. He's also not interested in speculative, volatile small companies. His way of weeding these out is to require at least $75 million in pre-tax earnings.
Gilead sails through this first test with ease. The company currently has several blockbuster drugs on the market that pushed its total revenue above $32 billion last year. These drugs are also extremely profitable, which allowed Gilead's pre-tax earnings to exceed $21 billion in 2015.
2. Consistent earnings power, not just future potential
Buffett believes that great businesses do not need to rely on a strong economy to produce strong results. That's why he likes to see a long history of profitability so he can get a sense for how companies perform during downturns.
While Gilead's revenue and net income have been under pressure in recent quarters, a look back at its revenue and net income over the past 10 years paints a clear picture of success.
While the trend has largely been up and to the right, Gilead's revenue and profit really took off in 2014, after it launched its hepatitis C cures Sovaldi and Harvoni. More recently, the company's top line has come under pressure, as AbbVie and Merck have launched competitive products that have forced Gilead to give pricing concessions in order to remain competitive. Still, the last decade shows that Gilead's earnings power is quite resilient.
3. Strong return on equity, with little or no debt
Great businesses are capable of generating high returns on equity without the need to load up their balance sheet with debt. Here's how Gilead stacks up both of these measures:
While Gilead's return on equity of 92% would likely make Buffett's mouth water, I think that the company's escalating debt levels could give him pause.
Gilead's debt levels have grown so much in part to fund its massive buyback program. While the company has successfully reduced its share count as a result -- shares outstanding are down 20% since January 2014 -- my hunch is that Buffett wouldn't be too excited about the leverage.
4. Management in place
While Gilead's current CEO, John Milligan, has only been in the top chair for a few months, his tenure with the company spans a few decades. Milligan joined Gilead in 1990 as a research scientist, but he quickly climbed the corporate ladder. The company promoted him to CFO in 2002, COO in 2007, and president in 2008. He finally became CEO this past March, after the company's longtime CEO, John Martin, stepped down.
Speaking of Martin, he also still remains quite active at the company. Martin currently serves as executive chairman of the board, so current shareholders will still be able to benefit from his leadership.
In all, shareholders look like to be in excellent hands with these two leaders running the show.
5. A simple business
One of Buffett's core investing principles is to stay within your "circle of competence" and only invest in businesses that you understand. Unfortunately, I have a hard time believing that Buffett would call Gilead a "simple" business with a straight face.
Gilead's revenue and profit are derived from selling drugs that treat or cure diseases. While that's an easy enough to concept to understand, it is much harder to understand where's Gilead's future revenue and profit are going to come from.
Currently, Gilead makes the majority of its revenue from just two diseases -- HIV/AIDS and hepatitis C. Gilead boasts a leading market share in both diseases thanks to hit drugs such as Truvada, Atripla, Stribild, Sovaldi, and Harvoni. However, competition in both of these markets is fierce, so Gilead needs to invest billions in R&D to maintain its edge.
So far, Gilead has succeeded in maintaining its leadership position in both markets. Recently launched drugs such as Genvoya, Odefsey, and Descovy in HIV and Epclusa in hep-C have helped it to stay a step ahead of the competition. The company is also investing heavily to hopefully build out its presence in treating cancer and NASH in the years ahead, which could provide new growth opportunities down the road.
However, Buffett would probably find this business model to be unappealing since Gilead is constantly forced to reinvent itself to remain competitive. In addition, it's difficult to wrap your head around the science of new drugs and handicap the chances of winning regulatory approval. That makes me think he would put this company in his "too hard" pile and move on to the next idea.
Is Gilead on Buffett's buy list?
Gilead only scores a three out of a possible five on Buffett's checklist, which suggests that it wouldn't ever be a serious contender to be brought into Berkshire's empire. Of course, just because Gilead isn't a Buffett stock doesn't mean it isn't worth owning. After all, the company continues to throw off billions of dollars in cash each year, and it has a number of interesting drugs in its pipeline that could one day reignite growth. In addition, shares have become so cheap that the company's dividend yield exceeds 2.5%. I find those figures to be attractive enough to warrant an investment. Perhaps you should, too.