Investors who haven't read Roger Hagstrom's The Warren Buffett Way could do a lot worse than putting the book near the top of their reading list for the summer holidays.
In the book, Hagstrom distils Buffett's investment process down to 12 tenets.
Hagstrom suggests that Buffett has Three Business Tenets he considers before investing in a company.
1. Is the business simple and understandable?
A review of businesses Buffett has investments in over the years show that he has regularly favoured simple to understand companies such as furniture retailing and chocolate retailing.
For example, consider the relative simplicity of Australia's largest natural gas infrastructure business APA Group (ASX: APA) which owns a suite of pipeline and infrastructure assets across Australia. With some careful research and analysis many investors could reasonably expect to gain a sound understanding of a firm such as this.
In comparison, energy giant Woodside Petroleum Limited (ASX: WPL) has operations globally and is exposed to the turbulence of oil markets. This stock is arguably much more difficult for many investors to understand and to ultimately value.
2. Does the business have a consistent operating history?
While speculating on a small company which is yet to make a profit or on a turnaround situation can lead to big share price gains, Buffett is only interested in investing in companies that already have sound and consistent operating businesses that can provide him with a steady stream of cash flow.
This tenet means Buffett would likely avoid companies yet to make a profit such as accounting software firm XERO FPO NZ (ASX: XRO) in favour of a company such as Ramsay Health Care Limited (ASX: RHC), which has a track record of consistently growing its revenue and earnings.
3. Does the business have favourable long-term prospects?
Buffett likes to remain focussed on the "knowable" while avoiding industries and businesses where he is uncertain of the outlook.
A current example of this is the newspaper and free-to-air television sectors. Companies such as Nine Entertainment Co Holdings Ltd (ASX: NEC) and Seven West Media Ltd (ASX: SWM) are struggling in the face of structural changes within their industries. Arguably Buffett would be concerned about the long-term prospects of these businesses which would lead him to avoid them in favour of other businesses with more appealing and certain long-term prospects.
