Warren Buffett attracts a lot of attention. As the world's third-richest person and most celebrated investor, thousands try to glean what they can from his thinking processes and track his investments.

While we can't know for sure whether Buffett is about to buy Ambac (NYSE: ABK) -- he hasn't specifically mentioned anything about it to me -- he has left us some clues as to whether it's the sort of stock that might interest him. Answering that question could also inform 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 and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno mumbo jumbo businesses.

Does Ambac 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 Ambac's earnings and free cash flow history:


Source: Capital IQ, a division of Standard & Poor's. Free cash flow is adjusted based on author's calculations.

Ambac hasn't consistently generated free cash flow and earnings; although this isn't unusual for the insurance industry, it's important that underwriting standards be conservative.

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 actually 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 put Ambac in context with other property and casualty insurers:

Company

Debt-to-Equity Ratio

Return on Equity (LTM)

Return on Equity (5-year average)

Ambac

N/A

N/A

N/A

Berkshire Hathaway (NYSE: BRK-A)

41%

9%

9%

Fidelity National Financial (NYSE: FNF)

22%

9%

10%

Wesco Financial (NYSE: WSC)

1%

3%

5%

Cincinnati Financial (Nasdaq: CINF)

18%

11%

11%

Source: Capital IQ, a division of Standard & Poor's.

Ambac has no debt-to-equity or return-on-equity ratio because the company's equity was vaporized during the financial crisis. This is not an enviable position for an insurer to be in. Things are looking dire.

3. Management
Ambac's CEO, David Wallis, has only been at the job since 2008, though he had worked at the company for a few years prior.

 4. Business
Buffett is obviously no stranger to the insurance industry -- it's not one that's generally subject to major technological disruption.

The Foolish conclusion
Whether or not Buffett would ever invest in Ambac, we've learned that it doesn't exhibit many characteristics of a quintessential Buffett investment: consistent earnings, high returns on equity with limited debt, and a long-tenured CEO.

Ilan Moscovitz owns shares of Berkshire. Fidelity National Financial is a Motley Fool Inside Value selection. The Fool owns shares of Fidelity National Financial. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.