Warren Buffett's value investing, applied to PSX
How Warren Buffett's idea of buying wonderful businesses at fair prices translates to the Pakistan Stock Exchange: the measures to check, the kinds of business that fit and don't, and the risks specific to Pakistan.
By the Nafa team · Updated · 5 min read
Warren Buffett's approach comes down to one idea: buy wonderful businesses at fair prices. PSX is a very different market from the American one he invests in, but the principles carry over well. This guide explains them and how they apply in Pakistan. It describes an approach, not a list of shares to buy.
The idea
Buffett wants two things that can sound contradictory: a great business and a sensible price. The businesses he likes share a few traits:
- profits that are predictable from year to year
- a lasting advantage that keeps competitors out, which he calls a moat
- little need for new capital to keep growing
- managers who spend the company's money well
On PSX, that means looking for companies that:
- earn a high return on shareholders' money, year after year, without heavy borrowing
- can raise their prices without losing customers
- turn their profit into real cash
- trade at a price that is reasonable for what they earn
The measures to check
Return on equity of 15% or more
Return on equity (ROE) is profit as a percentage of shareholders' money in the business. Buffett looks for companies that earn 15% or more over many years, not just in one good year. In Pakistan, where interest rates and inflation are high, a consistently high ROE is a strong sign of a real advantage. Every Nafa stock page shows the company's ROE and its yearly results.
Little debt
Debt makes good years better and bad years worse. Buffett prefers businesses that don't need to borrow to grow. On PSX, businesses that need little plant, such as branded consumer goods, tend to fit better than cement, steel or textiles, which need heavy, constant investment.
A sensible P/E
Buffett doesn't buy on P/E alone, but he won't overpay. A high P/E has to be justified by growth that is likely to last. Compare a company's P/E with its own history and with others in its sector. See the PSX companies with the lowest P/E ratios, and how to avoid value traps, because cheap and good aren't the same thing.
Dividends that confirm the profit
A dividend paid in cash, year after year, is evidence that reported profit is real. A long record of steady dividends says more than a single high yield. See PSX companies with the highest dividend yields.
Price to book
Price to book compares the share price with the company's net assets. Below 1 can mean a bargain, or a business in trouble. For businesses with high returns, a price of one to two times book value is a common comfort zone.
The kinds of business that fit
- Branded everyday goods. Food, drinks and household products bought every week. People in Pakistan stick with brands they trust, which lets these companies raise prices with inflation.
- Banks with strong deposit franchises. A bank that gathers cheap current and savings deposits, and runs at low cost, can earn high returns for decades. See banking stocks on PSX.
- Specialised chemicals and industrial inputs. Where customers face high costs to switch suppliers, or a distribution network is hard to copy.
The kinds of business that don't
- Commodity producers with no pricing power. Cement, steel and most textile makers sell products that are nearly identical, so price is the only way to compete, and profits swing with input costs and industry capacity.
- Businesses that depend on government decisions. Where profit hinges on subsidies, set prices or gas allocation, long-term earnings are hard to predict.
- Businesses that eat their own profit. If a company has to reinvest most of what it earns just to stand still, it can't compound value for shareholders.
Risks specific to Pakistan
- The rupee. The rupee has lost a lot of value over the past decade. Companies that sell in rupees but buy in dollars see their margins squeezed; businesses that can raise their prices hold up better.
- Tax changes. The super tax, sector levies and limits on bank dividends can cut profits without warning. How management handled past shocks is part of judging quality.
- Profit that isn't cash. Always compare profit with operating cash flow. A company reporting Rs 2 billion of profit and Rs 500 million of operating cash needs explaining. See how to read PSX financial statements.
Turning it into a screen
A simple screen in this spirit keeps companies that are profitable, trade below twice book value, pay a dividend yield of 2.5% or more, earn a return on equity above 10%, carry debt below twice equity and have more short-term assets than short-term debts. Ticker Analysts, the research site from the company behind Nafa, runs this screen daily.
A screen only produces a shortlist. Whether a company deserves a place in a portfolio depends on the things no number captures: management, competition and the risk of a change in policy.
