Fundamental characteristics of wonderful companies

Warren Buffett only invests in "wonderful companies", but how can you identify such a hidden gem? By analyzing Buffett's Letters to Berkshire Shareholders we deduce his definition of a "wonderful company".

"It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Warren Buffett

The following list contains the characteristics of a solid investment in Buffett's own words:

1. Market price significantly below the estimated Intrinsic Value (Margin of Safety)

"...the key to successful investing [is] the purchase of shares in good businesses when market prices [are] at a large discount from underlying business values."

Letter to Berkshire Shareholders (1985)

2. Above average and consistent Return on Equity

"Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital."

Berkshire Hathaway Owner Manual

3. Low debt/equity ratio

"We prefer businesses earning good returns on equity while employing little or no debt."

Letter to Berkshire Shareholders (1982)

4. Consistently high profitability

"We prefer demonstrated consistent earning power"

Letter to Berkshire Shareholders (1982)

5. Strong and sustainable competitive advantage

"In business, I look for economic castles protected by unbreachable 'moats'."

Letter to Berkshire Shareholders (1995)

6. Honest and competent management

"...we try to buy not only good businesses, but ones run by high-grade, talented and likable managers."

Letter to Berkshire Shareholders (1987)

7. Within Circle of Competence

"...we just stick with what we understand."

Letter to Berkshire Shareholders (1999)

Companies with the above mentioned criteria have in Buffett's opinion the highest likelihood of providing him and his shareholders with a good return on investment while simultaneously reducing downside risk. These "wonderful companies" are the only ones he is interested in. This approach greatly reduces the spectrum of possible investments, but the ones that remain are strong performers who are likely to provide healthy cash flows in years to come.

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