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 lululemon athletica (Nasdaq: LULU) -- he hasn't specifically mentioned anything about it to me -- we can discover 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 laid out the qualities he looks for in an investment. In addition to adequate size, proven management, 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 lululemon 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 lululemon'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.

Over the past few years, lululemon's earnings and free cash flow have grown substantially.

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 use an industry context.



Return on Equity (LTM)

Return on Equity
(5-Year Average)

lululemon 0% 39% 33%
Under Armour (NYSE: UA) 3% 16% 17%
Nike (NYSE: NKE) 6% 21% 22%
bebe (Nasdaq: BEBE) 0% (2%) 10%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months.

lululemon produces superior returns on equity while employing no debt. In fact, it was in large part for the company's high returns on capital that I recently purchased shares for the real-money Dada Portfolio I co-manage.

3. Management
Christine Day has been CEO since 2008. Dennis Wilson has been chairman since he founded the company in 1998.

4. Business
Clothing is not particularly susceptible to technological disruption, but the yoga boom is likely too recent a development for Buffett to feel comfortable investing in it.

The Foolish conclusion
Regardless of whether Buffett would ever buy lululemon, we've learned that the company exhibits many of the characteristics of a quintessential Buffett investment: growing or stable earnings and high returns on equity with limited debt.

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