My US colleague Amy Arnott recently wrote an article looking at the DNA of companies in Warren Buffett’s portfolio at Berkshire Hathaway.

I’ve taken her work and used Morningstar analyst ratings and financial ratios to try and identify companies that trade on the ASX that may fit Buffett’s criteria.

In my opinion the most important lesson that studying Buffett provides for all investors is his focus on being a student of business. In that vein this list should be used as a jumping off point to learn more about each business and the competitive environment it operates within.

Finding great companies in the age of index investing

In an era when index funds have overtaken actively managed vehicles, Berkshire Hathaway chairman and CEO Warren Buffett is holding on to his legacy as perhaps the greatest investor of all time.

He has often written about one core principle: He wants to buy pieces of companies, not stocks.

But what makes a great company? If you ask Buffett, it includes:

  • An economic moat
  • An outstanding management team
  • Thoughtful capital allocation
  • An easy-to-understand business
  • Actual earnings power and financial strength

The follow article digs into some of the key traits Buffett has focused on since he started his investment career nearly seven decades ago.

Trait 1: An economic moat

Above all else, Buffett looks for companies with a durable competitive advantage, or economic moat. Just as a circle of water or dry land protects a castle from intrusion, an economic moat protects a company from being encroached on by competitors.

In his extensive letters to shareholders over the years, Buffett has discussed several key moat sources, including a low cost of production, economies of scale, unique products that competitors can’t replicate, exceptional distribution systems, and a strong brand identity. 

Examples from Berkshire Hathaway’s investments:

  • Geico, a Berkshire subsidiary that has enjoyed a durable cost advantage by selling policies directly instead of paying sales reps.
  • Coca-Cola KO, which has profited from a strong brand, an extensive distribution network, and millions of customers who won’t switch to another beverage.
  • Apple AAPL, which boasts a carefully maintained ecosystem, favorable demographic trends, and indispensable products.


Appling the criteria to ASX listed shares

I am going to be picky and only include companies which receive a Wide Moat Rating from our analysts. That means we believe the company can sustain a competitive advantage for at least 20 years.

There are 19 ASX listed companies that receive a Morningstar Wide Moat rating from our analysts within our coverage universe:

You can read more about economic moats here.

Trait 2: An outstanding management team

Buffett also seeks out companies with outstanding CEOs. Some of the qualities he looks for are integrity, financial discipline, dedication to quality, maintaining a tight focus on their circle of competence, and thinking independently instead of falling victim to the “institutional imperative,” which involves resistance to change, making misguided acquisitions, catering to the business leader’s whims, and mindlessly imitating the strategy of other companies in their peer group.

Examples from Berkshire Hathaway’s investments:

  • Katherine Graham and Dick Simmons from the Washington Post Company (now known as Graham Holdings GHC). Buffett praised the late duo for their managerial skills, integrity, and dedication to treating shareholders well.
  • Capital Cities/ABC’s late executives Tom Murphy and Dan Burke, whom Buffett called the “best managerial duo” that he had ever seen thanks to their ability, integrity, and skill at both operations and acquisitions.
  • Coca-Cola’s late chairman and COO Donald Keogh, whom Buffett praised for his business talent and ability to bring out the best in people around him.

Appling the criteria to ASX listed shares

Any assessment of a management team is subjective. There is no Morningstar analyst rating that directly corresponds to an assessment of management although our Capital Allocation rating comes close which I’ve considered in the following trait.

Trait 3: Thoughtful capital allocation

This trait is closely related to the previous one. Buffett looks for companies with boards and management teams that consistently deploy their capital to build shareholder value over time. He avoids companies with executives who are prone to distractions, empire-building, frittering away money on acquisitions, and diluting shareholder value by issuing shares.

This line of thinking has heavily influenced how Berkshire Hathaway itself is managed. Buffett wrote somewhat sheepishly about the company’s 1986 purchase of a corporate jet (nicknamed The Indefensible) but ultimately came to appreciate that it made travel significantly more comfortable and efficient. He has also frequently written about Berkshire’s streamlined corporate staff and the value of share repurchases, which are a tax-efficient way to give each shareholder a larger stake in the company.

Examples from Berkshire Hathaway’s investments:

  • Coca-Cola, which has bought back 3.6 billion shares of common stock (as of Dec. 31, 2023) at an average price of $17.96 since it first introduced its share repurchase program in 1984.
  • The Washington Post Company, which Buffett praised for making share repurchases at low prices.
  • Capital Cities/ABC (now part of Walt Disney DIS), which Buffett admired for its thoughtful and effective acquisition strategy.
  • Apple, which has repurchased roughly $600 billion worth of its own shares over the past 10 years.

Appling the criteria to ASX listed shares

Leadership is ultimately an exercise in decision making and running a company is no different. CEOs make thousands of decisions over the course of their careers. Some are trivial and some can make or break the future of the company.

Morningstar’s capital allocation rating assesses the way that management spends their capital.

The capital allocation decisions that are made are based on the best utilisation of the capital to create value for shareholders – the owners of the company. This is not a static decision, and will vary based on the company, the industry and market conditions.

We can simplify this down to the three avenues for deploying capital - the balance sheet, investing in the business (internal and external) and shareholder distributions.

Our analysts rate capital allocation decisions as exemplary, standard, and poor. I have excluded any company that does not receive our top rating of exemplary.

There are 9 ASX listed companies that receive a wide moat rating and an exemplary capital allocation rating from our analysts:

  • Auckland Airport (ASX: AIA)
  • Brambles (ASX: BXB)
  • Cochlear (ASX: COH)
  • Deterra (ASX: DRR)
  • Endeavour (ASX: EDV)
  • James Hardie (ASX: JHX)
  • PEXA Group (ASX: PXA)
  • Technology One (ASX: TNE)
  • Wesfarmers (ASX: WES)

You can read more about capital allocation here. 

Trait 4: An easy-to-understand business

This trait is a close cousin to the previous one. Buffett values simple, easy-to-understand business models and shuns complexity. For this reason, he avoided technology stocks for many years (although he eventually bought shares in IBM in 2011 and Apple starting in 2016). He has also generally shunned other rapidly evolving industries, such as airlines, paper, and investment banking.

Examples from Berkshire Hathaway’s investments:

  • Gillette (now part of Procter & Gamble PG), a business that Buffett described as “very much the kind we like.” It has a standardized product that needs to be replaced often, leading to brand loyalty and repeat purchases.
  • See’s Candies, which has a similarly uncomplicated business of making candy (mainly chocolate) and selling it.
  • Nebraska Furniture Mart, which was founded by Rose Blumkin, a Russian immigrant, in 1937. Blumkin (officially known as Mrs. B) described her company’s business model as, “Sell cheap and tell the truth.”

Appling the criteria to ASX listed shares

The simplicity of a business is subjective. Yet some businesses have less factors that influence the future cash flows they generate. If those future cash flows are more predictable the business is by definition easier to understand.

The Morningstar uncertainty rating assesses the predictability of future cash flows. Each company under our analyst coverage receives an uncertainty rating of extreme, very high, high, medium, and low.

I’ve picked companies with a medium and low uncertainty rating as a proxy for easy-to-understand businesses. The same 9 ASX listed companies remain on my list with a low or medium uncertainty rating, wide moats and exemplary capital allocation ratings.

You can read more about business risk here.

Trait 5: Actual earnings power and financial strength

Buffett has often written about the limitations of audited financial statements. One particularly good quote:

It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.
Warren Buffett

He made a sharper critique in his 2023 letter to shareholders, deriding reported net income figures as “worse than useless.”

There are two main reasons for his skepticism about publicly reported financial results. First, they provide only a snapshot (either annual or quarterly) of a company’s results. Second, accounting earnings can frequently be distorted by unrealized capital gains and losses, mergers and acquisitions, tax quirks, and other issues.

To avoid these problems, Buffett instead focuses on companies with underlying earnings power and financial strength. His preferred measure is operating earnings, which strips out items such as noncash inventory costs, depreciation, goodwill amortization, and deferred taxes. He also uses other metrics such as return on equity capital and free cash flow.

Examples from Berkshire Hathaway’s investments:

  • The Washington Post Company, which benefited from a subscription business model and low debt.
  • Geico, which has a rock-bottom cost structure and enjoys the benefits of float, which is the money an insurance company receives upfront and can invest until claims are paid out.
  • Burlington Northern Santa Fe, which requires heavy capital investments but provides a fundamental service that’s essential to people and businesses around the country.
  • See’s Candies, which has a low cost structure and millions of repeat customers for its boxed chocolates.
  • MidAmerican Energy, an electric utility that operates in Iowa, Illinois, Nebraska, and South Dakota. While the utilities business is heavily regulated and capital-intensive, it can generate attractive profits over time.

Appling the criteria to ASX listed shares

There are many different criteria we can use to judge each of our remaining 9 companies. I’ve chosen a couple that align to Buffett’s high-level view of what is attractive in a business. Some investors may choose other criteria.

Given that Buffett prefers to strip out the impact of accounting related adjustments to earnings I looked at the EBITDA margin. EBITDA refers to earnings before interest, taxes, depreciation, and amortisation. The margin is how much EBITDA a company generates for each dollar of revenue.

I have narrowed down the list of 9 ASX listed companies with wide moats, exemplary capital allocation ratings and low or medium uncertainty. I’ve taken those companies that fall within the top 25% of highest ASX listed EBITDA margins. That leaves two companies: Technology One and Deterra.

Buffett also likes companies that have high ROE or return on equity. Return on equity measures the net profits a company generates based on each dollar of capital that is invested.

There are 6 companies that trade on the ASX with wide moats, exemplary capital allocation ratings and low or medium uncertainty ratings that fall within the top 25% of ROE. Those companies are Brambles, Cochlear, Deterra, James Hardie, Technology One, and Wesfarmers.

Finally, I’ve looked at financial strength. This is already captured in our capital allocation rating as one of the three criteria assessed by our analysts is balance sheet strength. To add another screen, I’ve reviewed the debt-to-equity ratio. This is a measure of how much debt a company has compared to assets. Lower is better when looking at debt to equity.

Using the same overarching moat, capital allocation and uncertainty criteria there are 3 companies within the 25% lowest debt to equity ratios of ASX listed shares. Those companies are Cochlear, Deterra, and Technology One.

The only ASX listed companies that pass all the criteria in this article are Technology One and Deterra. Does this make these the perfect companies for Buffett? Of course not. Anytime a financial metric is used to assess a company it needs to be put within the context of the overall business.

Remember that more than anything Buffett is a student of business. Understanding the business contextualises a financial metric. With context an investor may choose to ignore a certain metric or weight it less in an overall assessment.

A couple examples from our list may be illustrative. EBITDA margin measures how much EBITDA is generated from a dollar of sales. All things being equal an investor prefers a higher margin. Yet different businesses naturally have different margins.

Endeavour is a perfect example. This is a high-volume retail business and comparing their margin to companies that operate in different industries doesn’t make any sense. Endeavour does not have an EBITDA margin that falls within the top 25% of ASX listed shares. They never will. What matters is how their margin tracks against similar businesses. The fact that Endeavour’s EBITDA margin is nearly 5 times higher than Woolworths may be a better comparison.

Debt to equity is also a measure that can’t be viewed in isolation. Some companies can handle higher levels of debt than others. If a company has steady and predictable cash flows coming in the door more debt can be held. This is how banks assess borrowers. Longer histories of employment and higher salaries are favoured by banks.

No one measure is enough to select or reject a share. Any assessment must be subjective because all businesses are different. Deterra scores off the charts in all the financial metrics I’ve used in this article. Yet Deterra is a unique business model as the owner of a royalty over BHP mining sites that provide cash flow without exposure to capital or operating costs. It is up to each investor to decide if Deterra (or any company) is a good or bad investment opportunity. That is the art in investing.

Conclusion

The one measure that has not been used in this analysis of ASX listed share is valuation. Buffett wants to buy great businesses at attractive prices. And it can be rare for great businesses to be on sale.

That doesn’t make this effort meaningless. The five traits described above aren’t rocket science, but they may be deceptively straightforward. Buffett himself has described investing as “simple, but not easy.”

It’s highly unlikely that any individual—or professional—investor would be able to replicate Berkshire Hathaway’s record by applying these precepts. Indeed, Buffett has advocated broadly diversified index funds with low fees as the best choice for most investors. For those willing to take on the risk of individual stocks, though, focusing on the five qualities above is an excellent starting point.