Finding Stocks the Warren Buffett Way

Part 2: Monopolies vs. Commodities Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right. Buffett is a buy-and-hold investor who prefers to hold the stock of a good company earning 15% year after year over jumping from investment to investment with the hope of a quick 25% gain. Once a good company is identified and purchased at an attractive price, it is held for the long-term until the business loses its attractiveness or until a more attractive alternative investment becomes available.

Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types:

Commodity-based firms, selling products where price is the single most important factor determining purchase. Buffett avoids commodity-based firms. They are characterized with high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is key for the long-term success of these types of firms.

Consumer monopolies, selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

While Buffett is considered a value investor, he passes up the stocks of commodity-based firms even if they can be purchased at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way. The stock of a mediocre business treads water.

How do you spot a commodity-based company? Buffett looks for these characteristics:

• The firm has low profit margins (net income divided by sales);
• The firm has low return on equity (earnings per share divided by book value per share);
• Absence of any brand-name loyalty for its products;
• The presence of multiple producers;
• The existence of substantial excess capacity;
• Profits tend to be erratic; and
• The firm's profitability depends upon management's ability to optimize the use of tangible assets.

Buffett seeks out consumer monopolies. These are companies that have managed to create a product or service that is somehow unique and difficult to reproduce by competitors, either due to brand-name loyalty, a particular niche that only a limited number companies can enter, or an unregulated but legal monopoly such as a patent.

Consumer monopolies can be businesses that sell products or services. Buffett reveals three types of monopolies:

Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. Nike is a good example of a firm with a strong brand name demanded by customers. Any store selling athletic shoes must carry Nike products to remain competitive. Other examples include leading newspapers, drug companies with patents, and popular brand-name restaurants such as McDonald's.

Communications firms that provide a repetitive service that manufacturers must use to persuade the public to buy the manufacturer's products. All businesses must advertise their items, and many of the available media face little competition. These include worldwide advertising agencies, magazine publishers, newspapers, and telecommunications networks.

Businesses that provide repetitive consumer services that people and businesses are in constant need of. Examples include tax preparers, insurance companies, and investment firms.