10 UK shares that Warren Buffett might buy

Warren Buffett, 92, still has plenty to teach other investors. Stock screen expert Ben Hobson uses Buffett’s technique to find local companies the Sage of Omaha might want to own.

Warren Buffett is one of the world’s most celebrated investors, and this week he reached the ripe old age of 92. Over a staggering number of years, the Sage of Omaha has not only built vast wealth for himself and shareholders of his company, Berkshire Hathaway (NYSE:BRK.A), but he’s also been an inspiration to investors everywhere.

No matter how many times you see financial headlines asking whether Buffett has lost his touch, his calls almost always come good.

Take technology. For many years he was teased for his reluctance to buy into new trends in software and the internet, especially in the early days. But that wariness of investing outside his sphere of competence saved him from the dotcom collapse in 2000. In the aftermath, he was the one picking up bargain-priced shares in traditional industries.

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These days technology is very much part of the Berkshire portfolio, with industry giant Apple Inc (NASDAQ:AAPL) representing more than 40% of its ownership of public stocks.

In bad times, of course, everyone wants to know what Buffett is doing. And for what it’s worth, the major pullback in markets this year has seen him increasing Berkshire’s exposure to energy companies such as Occidental Petroleum (NYSE:OXY).

None of this is by accident. Buffett’s latest moves follow a remarkably consistent pattern of behaviour. Over time, his once pure-value focus morphed into an obsession with business quality, particularly when it’s ‘on sale’ in the market.

With so much investing wisdom to choose from it’s hard to pick one quote or idea that sums up ‘the Buffett way’. But one concept I think really does stand out is the importance he places on competitive advantage.

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In search of exceptional companies

Buffett’s view is that companies with some kind of special advantage have the potential to generate and compound outsized returns for their shareholders over much longer periods than you’d normally expect from a business.

Whatever the advantage might be, it protects profitability by making life difficult for competitors. It could be a special type of intellectual property, valuable brands or regulatory authorisations or licences. It could be large or specialist production know-how or a distribution network that’s hard to replicate. It could be a particularly sticky customer base that either can’t or won’t go anywhere else.

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Buffett refers to this kind of strength as an ‘economic moat’. And it’s the ones that are the most durable, the deepest and widest, that offer the best protection.

How to measure a competitive advantage

As an investor, how can you really know if a company has a strong competitive advantage or not? One way would be to look at observable traits such as how many rivals it has and how many alternative products or services there are. Are there many new entrants to the industry and do the company’s customers and suppliers have much negotiating strength?

These questions are part of what is known as Porter’s Five Forces, and it’s a useful framework if you can find the precise answers. But another option is to look at a handful of accounting measures and ratios that can be big giveaways about the quality and competitiveness of a business. Here are some measures to look for:

• Operating Margin greater than 10% (and greater than 10% on average over five years). This is a go-to measure of profit on sales after costs. High margins are always desirable and a useful guide to defendable profitability. Double-digit consistency over time is ideal.
• Return on Capital Employed (ROCE) greater than 15%. This is a measure of business efficiency and tells you how good the company is at squeezing a profit from the capital it reinvests in itself to grow.
• Return on Invested Capital greater than 15% (and greater than 15% on average over five years). This is slightly different from ROCE and gives you an indication about the productivity of the company’s assets. It’s a crucial indicator about the strength of the business.
• Levered Free Cash Flow Growth greater than 5% on average over five years. This is the amount of cash left over once the business has paid all its financial obligations. Cash is king, and it’s a hallmark of strong firms with robust finances.

Whatever measures you look at, it’s important to consider the medium-term average, not just what happened in one particular year. That way you get a more accurate idea of how the company performs and whether its high levels of profitability are sustainable.

If you apply some of these quality rules to the UK market, you find a number of names that the market already knows are great businesses - and perhaps a few that are less well known:

It’s important to remember that not all companies have competitive strengths for the same reasons. Interactive media companies such as Rightmove (LSE:RMV)and Auto Trader (LSE:AUTO) have well-known brands and services that consumers think about first when it comes to buying houses or cars.

Others, such as Somero Enterprises (LSE:SOM), iEnergizer (LSE:IBPO), Cerillion (LSE:CER)and Judges Scientific (LSE:JDG) are relatively small but have specialist know-how in their respective fields that make them attractively profitable.

Buffett’s view on the role of competitive advantage is a really useful guide to how great investors think about the business cycle and how robust businesses can build and defend their profitability. For investors, these firms have the power to grow and compound returns at above-average rates.

These firms can be hard to track down, and the nature of competition and constantly changing competitive landscapes means they are always in flux. But with a few financial clues you could be on the path to finding them.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.