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 Merck
In his 10-K filings, Buffett lays out the qualities he looks for in an investment. In addition to adequate size 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 Merck 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 Merck'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.
Merck generates fairly volatile earnings, in large part due to merger and restructuring charges from major acquisitions over recent years.
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 them in context:
|
Company |
Debt-to-Equity Ratio |
Return on Equity (LTM) |
Return on Equity (5-year average) |
|---|---|---|---|
|
Merck |
31% |
2% |
22% |
|
Pfizer |
50% |
9% |
12% |
|
Eli Lilly |
56% |
46% |
26% |
|
Bristol-Myers Squibb |
35% |
30% |
26% |
Source: Capital IQ, a division of Standard & Poor's.
Though earnings last year suffered from the aforementioned charges, historically the company has generated reasonably high returns on equity.
3. Management
CEO Ken Frazier has been only been at the job the start of the year, though he served in other positions at the company for a few years prior.
4. Business
Pharmaceutical companies must constantly invent new drugs to replace old ones as their patents expire, and Merck is certainly no exception. (Though it should be noted Buffett owns a large stake in Johnson & Johnson).
The Foolish conclusion
Whether Buffett would ever invest in Merck, we've learned that it doesn't particularly exhibit the characteristics of a quintessential Buffett investment: consistent earnings, high returns on equity with limited debt, tenured management, and a straightforward industry.
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