Buffet’s litmus test for quality stocks

Buffet’s litmus test for quality stocks

When Warren Buffett was asked to distil the essence of investing success, he offered the following:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

Quality is: low debt and high rates of return

I am wedded to a relatively strict definition of a quality business. A company should sustainably produce high returns on equity with little or no debt. This suggests a competitive advantage.

Typically, when companies generate high rates of return, they attract competition. The easiest and most mindless way for new entrants to compete is to offer cheaper prices, which, of course, reduces gross margins, putting pressure on net margins and therefore returns on equity. Therefore, if a company can generate a high rate of return on equity sustainably, it has been able to successfully fend off those competitors, or sufficient barriers to entry exist to block or slow the entrance of competitors in the first place.

A high level of debt relative to equity can artificially boost the returns on equity, but of course, debt carries risk. A company generating high rates of return on equity with little or no debt has all the attractive qualities without the risk. Of course, there may be a point in time where a business can employ debt profitably, but when very high returns are being generated after the interest is paid, the debt usually isn’t needed for long and eventually disappears from the balance sheet. By definition, therefore, a quality business has a competitive advantage so powerful it doesn’t need to carry debt.

It wasn’t that Buffett disliked technology

For years, Warren Buffett and the late Charlie Munger claimed they didn’t like technology. After massively underperforming the market during the Tech Bubble of 1999 and early 2000, many commentators explained that they didn’t understand technology. I have never believed that. Two Mensa geniuses with a lifetime of business experience and photographic memories can pretty much back-solve whatever they put their minds to.

Instead, the issue with technology is the fast-paced nature of change, which makes the formation of a view about the future competitive landscape almost impossible with any certainty. If one cannot establish whether a business will be the long-term winner in a competitive environment it is impossible to say the business is ‘easily understandable” nor whether its earnings are ‘virtually certain to be materially higher five, 10 and 20 years from now”.

That is fundamentally why Berkshire Hathaway had been devoted to businesses with predictable outlooks. That is until Intel was briefly owned in 2011, and subsequent holdings in Amazon, Apple and BYD.

Berkshire’s position in Apple has received the most commentary, but importantly the holdings does not suggest Buffett has strayed from his oft-touted principles of investing.

On the contrary, Apple, along with its peers, such as Facebook, Amazon, Microsoft, and Google, possesses the very qualities that Buffett has insisted should characterise a portfolio.

Not only are these companies’ earnings growing rapidly, but as they’ve grown, they’ve become more profitable. By that I mean returns on equity have increased as the equity has grown. Think of that like a bank account that earns higher rates of interest as the amount of money in the bank account increases. That really is the first prize in equity investing.

The enduring appeal of the Tech Giants

I looked at the returns on equity for each of the FAANGs (Facebook, Apple, Amazon, Netflix, and Alphabet) for the last five years and discovered something universal, as these companies grew, they became more profitable.

Table 1. Return on Equity (ROE): 2015-2024

Source: Annual reports, Yahoo Finance, Nasdaq, and Visible Alpha.

Each company demonstrates a much higher return on equity in 2024 than in 2015.  While some of the increases – Apple for example – is due to share buybacks (I wonder if Buffett influenced the buybacks as he did at CocoCola over decades) – the bulk of the increases are due to improved profitability, for example at AWS (Amazon), as well as strong cloud and software margins (Azure at Microsoft, and Alphabet). Improvements in profitability, as measured by return on equity, can also be attributed to the network effect and flywheel competitive advantages, as each of these companies has become a monopoly, which can produce the most valuable of all competitive advantages.

Their most profitable competitive advantage is the ability to raise prices without a detrimental impact on unit sales volume. In a world of declining real rates of return, such pricing power and growth are scarce and highly prized by investors, which explains their remarkable share price performances.

As an aside, in his book Monopolized: Life in the Age of Corporate Power author, journalist and Executive Editor of one of the most important political magazines today, the American Prospect, Dave Dayen, notes that practically everything we buy, everywhere we shop, and every service we secure comes from a heavily concentrated market.

In a 2020 interview about monopoly power in the U.S, Buffet was labelled “America’s Folksiest Predator”. In that interview, Dayen commented on Buffett:

“This is a guy whose investments philosophy is literally that of a monopolist. I mean, he invented this sort of term, the economic ‘moat’, that if you build a moat around your business, then it’s going to be successful. I mean, this is the language of building monopoly power. He not only looks for monopolies in the businesses he invests in, but he takes it to heart in the business that he’s created, Berkshire Hathaway. Berkshire Hathaway owns something like 70 or 80 or 90 companies and they have large market shares in all sorts of areas of the economy”, adding, “It’s kind of like an old school conglomerate from the sixties and seventies, but there are certain facets of it, where he’s clearly trying to corner a market. Buffett’s initial businesses that he actually outright purchased were newspapers. It started with the Buffalo News in Buffalo, New York. And he used anti-competitive practices to put the competition, his rival newspaper, out of business. That was literally his MO there.”

Elements of monopoly and anti-competitive behaviour

The Magnificent Six (not ‘Seven’ because we exclude Tesla for its obvious lack of pricing power) demonstrate at least some of the hallmarks of monopoly power and some of these companies, as well as their peers and counterparts, engage in anti-competitive behaviour.

Some years ago, I read Spotify’s developer agreement. Yep, Fun! In Section IV Restrictions, Part 1 General Restrictions, clause 1.f. reads:

“Do not use the Spotify Platform, Spotify Service or Spotify Content in any manner to compete with Spotify or to build products or services that compete with, or that replicates or attempts to replace an essential user experience of the Spotify Service, Spotify Content or any other Spotify product or service without our prior written permission.”

Many would argue this is blatantly anti-competitive. Another business, therefore, might not be able to build a tool that transfers a user’s list of songs from Spotify to another service provider even if the consumer and the artists who produced the songs might benefit from the transfer.

Up until Trump, many investors believed the presence of such behaviour put these companies in the sights of antitrust lawmakers, generating new risks for investors. But geopolitical competition, particularly with China, means U.S. lawmakers are unlikely to hobble their domestic champions.  Investors can collectively breathe a sigh of relief even if smaller businesses that might hope to compete cannot.

Not all technology companies have ‘virtually certain’ profits

Indeed, in the next tier of technology companies – and those companies in the many tiers below that – they don’t generate a profit and some don’t even generate revenue. Of course that has not stopped many of their share prices surging. Indeed, companies like nLight, Aeva Tech and Ouster in the U.S. have rallied by at least 200 per cent since April 9 lows, despite the fact that they are unprofitable.

What happened here is that hopes of rate cuts have made it appear safe for investors to pursue growth investments again. The strategy’s growing popularity then leads to a self-fulfilling and virtuous spiral in which success reinforces the approach’s validity, drawing more investors in.

Consequently, investors are pursuing growth irrespective of whether the company displays the quality characteristics required to sustainably generate highly profitable growth. The absence of profit or even revenue is not a hurdle to investment success and therefore not relevant.

But eventually it will be. And so you should stick to quality – those tech businesses that display the characteristics described in this blog post.

While other investors might be happy to pay top dollar for AI, cloud and robotics companies, Buffett’s lesson about quality and certainty of future growth should not be forgotten. Revenues may be growing but you want to own a business whose earnings are virtually certain to be materially higher in five, 10 or 20 years from now.

Note the imperative to be ‘virtually certain’ about earnings or profits. One can only be ‘virtually certain’ if, in addition to growth, the company has a sustainable competitive advantage. You need to identify what that competitive advantage is. In the absence of high barriers to entry, defendable intellectual property, or monopoly conditions, the sustainability of highly profitable growth will be in question and the nature of your paper profits will be fleeting.

Disclaimer: 

The Polen Capital Global Growth Fund owns shares in Amazon, Alphabet and Microsoft. This article was prepared 3 July 2025 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade any of these companies you should seek financial advice.

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.

Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances. 

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.