Berkshire Hathaway Acquisition Criteria

Reference:  Berkshire Hathaway 2017 AR page 23.

Why is this important?

I think we can learn a lot from Warren Buffet, the world's greatest investor of all time.
To me, Buffet's investment strategy centres on:

1. Carefully selecting businesses with superior long term economic characteristics, and 

2. Comes with honest and trustworthy management who will take care of shareholders, and

3. Looks to buy at a fair / attractive price, and

4. Once he finds such a business, he will then try to own that business in its entirity (because good businesses are very hard to find), and

5. With its economic moat, and presumably growing earnings and cash to shareholders, then, look to hold this business forever (.. yes forever ...) whilst the superior business model remains intact.

Does this strategy makes sense to you?  

To me, yes.  When we find the rare, long term winners that will keep growing its earnings and shares its bigger and bigger profits with shareholders over time, it doesn't make sense to sell the stock for a one-time profit, and lose all the future income.  Buffet has many times stated that he's not into short term gains, unless there is an extraordinary euphoria that completely overvalue the business so much that it is no longer rational to own such a business. 

How to find such a company?

I believe there are more than just 1 interpretation of a Superior Quality Company.
It is interesting to start from what Buffet actually writes about this topic.
Looking at the 6 criteria above, I think we can summarize as follows:

1. Consistent earnings power over say past 10 years (he's not interested in future projections which anyone can claim - he's after demonstrated past earnings).  

2. Good returns on equity over say past 10 years (there's a few ways to define this, perhaps the simplest may be EPS / NAPS).

3. Business deploy little / no debt (there's some logic to this, a business that is highly leveraged might not be sustainable in the future when it encounters difficulty and risks bankruptcy/insolvency for example.  Many ways to measure this, perhaps the simplest may be Net borrowings / NTA.  But I expect this to vary by industry type - e.g. banks business model are highly leveraged).

4. Business model that's easy to understand (to me, this relates to understanding 1, 2 and 3 above in terms of its sustainability and predictability over the next 10, 20 years - do we really understand how the business retains its superior business model in the future).

What does these 4 criteria means?  To me, I think it can be boiled down into 2 essence:

1. We must really know, truly understand, beyond doubt, how the superior company makes increasing profits in the future.   Out of 100 companies, pick the best 1 or the Top 3, believing that the rest are rubbish, average, not sustainable, not worth owning, etc.  The better you are at discerning, the better the quality discovered (probably).   Have objective principles to discern and differentiate.

2. We must be convinced beyond doubt, that this company is trustworthy and will share its rising profits with shareholders, and not keep it to themselves. 

Any short cuts?

There are, but they have opportunity costs/not full-proof.  Simple rules means some gems will fall through the crack.

E.g. one of these criteria could be as follows:

1. Rising EPS over past 10 years.
2. Rising DPS broadly in line with rising EPS over past 10 years.

Why DPS over 10 years? 

There's pros and cons.  The pros is that it is harder to do accounting manipulation of long term DPS - the signs are easier to detect.   Whereas stocks that doesn't pay dividends - it is much easier to do accounting manipulation even over 10 years to show rising EPS.  You got to know where to look and sometimes, it takes too much work.

Another pro is to eliminate/differentiate from stocks that pays high DPS for short term, or 1 year or one time.  These cyclical or one-timers don't  fit Buffett's strategy to own the business forever.  Cyclical stocks are better off bought during cycle lows and sold during cycle highs, rinse and repeat.

DPS is also demonstration and proof - especially over past 10 years - that this company truly shares its profits with shareholders.  It shows, the Board and management thinks about the shareholders every quarter, every 6 months, every year.

What are the limitations of such an approach?

Many.  For example:

- You will miss the few superior stocks that hasn't paid dividends yet.   (i.e. Opportunity loss.). 
- Some companies with high borrowings may show rising EPS and rising DPS but will eventually go bust due to excessive leverage and borrowings.  So, there's no substitute for really understanding the business model, including its long term sustainability.
- Other opportunity losses may be missing rising stars with less than 10 year history (i.e. Opportunity loss).
- You still have to look at its payout ratio and long term sustainability of these dividends paid out.
- Past statistics alone has limitations - e.g. it doesn't look forward, hence, still important to also look forward to understand its future threats/potential weaknesses (assuming management are competent to identify opportunities and capitalizing on their strengths). 
- etc.

There are no one perfect simple approach / guarantees in the stock market.

Bottom line?

Don't forget Buffet's requirements to select superior, quality companies for the long term. 
The idea is simple and rational, but requires some honest effort.
He and others like him has used this approach successfully for many, many decades.