Warren Buffett's Surprising Key To Picking A Great Investment

By David Sterman
December 26, 2012

Each week, one of our investing experts answers a reader's question in our InvestingAnswers' Q&A column. It's all part of our mission to help consumers build and protect their wealth through education.

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Q. What's the single most important thing to know about a company before you buy its stock?
- Bea, Richmond, Va.

This week's question will be answered by InvestingAnswers investment analyst David Sterman:

A. Bea, that's a great question, and I had to chew on that one because there are several ways to answer that.

For professional investors such as hedge fund managers and mutual fund managers, the answer is a simple one: quality of management. These investment pros spend a huge amount of time getting to know management teams, watching their words and actions quarter after quarter. By building up a long-term relationship with CEOs and chief financial officers, they can better understand the company's vision -- and its ability to execute on that vision.

In fact, it's probably the single greatest investing factor for investment legend Warren Buffett. Whenever his investment firm, Berkshire Hathaway (NYSE: BRK-A), acquires a company, Buffett is quick to point out the quality of the management team. Indeed, he insists that these managers stick around, and keep running the acquired business.

Of course, most of us don't have the executive-level connections to really assess the quality of management.  But here's what you can do. Listen to what management has said in the past, and see if they have delivered on their promises. The easiest way is to listen to the company's three or four most recent conference calls and listen to the goals and expectations that management lays out for the company. In subsequent quarters, management should be explaining how it was able to meet its goals, and not simply apologize for missed targets. "We'll do better next time," is an oft-heard refrain from bad management teams. Seasoned investors know that "next time" never seems to arrive.

But if you don't have the time or inclination to wade through long conference calls, there is one crucial step you can take to find winning investments: In a nutshell, the best companies get high marks for both their balance sheets and their cash flow statements.

Starting with the balance sheet, it's always wise to focus on companies with an ample amount of cash and a manageable amount of debt. (A good rule of thumb is to look for cash that is at least twice as much as long-term debt). This kind of financial strength ensures that the company will be able to weather any economic downturn. Recall that automaker GM (NYSE: GM) carried way too much debt when the global economy tumbled in 2008, and eventually had to declare bankruptcy.

But you also want to be assured that a company's balance sheet will be getting stronger in the years ahead, and not weaker. And that means a solid history of positive operating cash flow -- in any economic climate. Positive cash flow means a company is adding cash, or subtracting debt from its balance sheet, which provides a company with several investor-friendly options. A company with rising cash can boost its dividends, buy back shares or make growth-inducing acquisitions.

Bea, even though you asked about the single most important item that every investor should look at, I would like to add a another item to the list: operating profit margins. This is a company's operating profits divided by its revenues. For example, a company with $150 million in sales and $30 million in operating profits has an operating profit margin of 20% (30/150). The key is to focus on companies with rising operating profit margins. That's a sure sign that the company is able to handle more business without a commensurate rise in expenses.  In effect, every new dollar of business is that much more profitable than the last one.

Conversely, falling operating profit margins are a worrisome sign. That means the company is spending too much money chasing the next dollar of revenue. Or it means that the company is cutting prices just to win business.

The financial statements can clue you into the health of a company. It's best to narrow your investment choices to only those firms which sport bullet-proof balance sheets and expanding levels of profitability.

Thanks for your question!

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