In September 2020, Warren Buffet picked up 5% stake in 5 Japanese trading companies: : Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo
How did his research analysts discover these companies? And, what instructions did he give them?
I analyzed the balance sheets of these companies and found the following common traits.
1. Cash and equivalents
Though the trading companies were reporting net losses because of COVID-19, their cash and equivalents exceeded their equity capital.
The first condition is
(Cash and Bank Balances + Short-term liquid investments) greater than equity capital
You can try this variation as well
(Cash and Bank Balances + Short-term liquid investments) greater than or equal to 20% of (equity capital + free reserves)
2. Operating cash flows
The trading companies were reporting net losses because COVID-19 had adversely hit many of their assets. So, the companies were impairing those assets resulting in a net loss.
As impairment is a non-cash charge, the cash flows ended up positive. Depreciation, also a non-cash charge, played a role.
So the second condition is:
Operating cash flows are positive
The third condition is:
Operating cash flows greater than net profit/loss
3. Book Value
The companies were available at a price lower than their book value.
The fourth condition is:
Latest Price lesser than Book Value
4. Dividend Consistency
Perhaps you can verify this manually: The company should have a consistent dividend payout record. In India, PSUs would qualify I guess.
5. Price to Sales
The company should be valued cheaply. Its market price to sales per share ratio should be low. Anything lower than 1 is great. However, if the company pays dividends consistently, then it may not be available at lower than Price/sales of 1. So, look for companies with a P/S of up to 4.
The fifth condition is:
Price/Sales Ratio lesser than 4
Latest Price divided by (sales divided by number of shares) lesser than 4
(Use 1-2 if the company does not pay dividends)
6. Debt Reduction
The company should ideally make an effort to reduce debt.
Your sixth condition is
TTM Debt lesser than Previous Year Debt
TTM = Trailing Twelve Months
7. Reduction in Expenses
When the going gets tough, strong companies restructure and cut expenses:
The seventh condition is
TTM expenses less (depreciation + impairment) lesser than Previous year expenses less (depreciation + impairment)
This is something you need to check up on manually. Information will be available in the annual report and in corporate announcements.
The gist is that the company should be doing its best to turn crisis into opportunity, and it should have something to look forward to.
That’s it. Create a screener of the doable conditions above, perform the suggested manual checks, and share your picks.
Any questions? Feel free to ask in the comments section.